Blurring the Lines between Banking & Sovereign Risk
Assessing the Implications of Sovereign Crisis 2.0 on U.S. Capital Markets November 2010

Tom Joyce Debt Capital Markets Strategy ( (212) 250 - 8754 )

Javier Guzman Debt Capital Markets Strategy ( (212) 250 - 3464 )

Deutsche Bank Securities Inc., a subsidiary of Deutsche Bank AG, conducts investment banking and securities activities in the United States.

“Irish banks will become significantly smaller than they have in the past, so that they can gradually be brought to stand on their own two feet once more.” more ~ Brian Cowen, Irish Prime Minister (Nov 21, 2010) “We have to fund ourselves as a state with senior debt. And other banks have to fund themselves with senior debt. You cannot send out a message in an economy like Ireland that senior debt can be dishonored. We're far too dependent on international investment." ~ Brian Lenihan, Irish Finance Minister (Sept 29, 2010)

“There may be a contradiction between the interests of the financial world and the interests of the political world. We cannot keep explaining to our voters and our citizens why the taxpayer should bear the cost of certain risks and not those people who have earned a lot of money from taking those risks.” ~ Angela Merkel, German Chancellor (Nov 11, 2010) "Investors must share the cost of sovereign debt restructuring. All stake holders must participate in the gains and losses of any particular situation.” ~ Christine Lagarde, French Finance Minister (Nov 10, 2010) “What is better than to sit at the end of the day and drink wine with friends, or substitutes for friends.” ~ James Joyce, Irish author (1882 – 1941)

1. Introduction

2. The “Irish Crisis” A. The Banking System B. The Sovereign

3. Potential Solutions

4. Potential U.S. Capital Markets Implications

Introduction I t d ti
Section 1

Key Considerations in Sovereign Risk Analysis
Too often, sovereign risk analysis focuses narrowly on the absolute amount of government debt, and the liquidity profile of g the sovereign However, a number of other critical factors must also be considered

Key Factors Total public sector debt Total private sector debt Debt ownership profile Dependence on capital markets / liquidity p q y profile “Confidence” with investors

Critical Questions • • • • • • • • • • • • • • • • • • Size vis-à-vis the economy? Trajectory? Distribution across financial sector, corporate sector, and at the consumer level? Foreign ownership percentage? Investor profile? Reliance on international capital markets? Liquidity? Size and strength of domestic bond market, if any? g , y Reputation issues, if any, on quality of data? Historical track record with key government statistics? Extent of power over own currency? Is the sovereign a significant global reserve currency? Are their technical reasons for strong demand even if fundamentals have some weaknesses? Flexibility and competitiveness? Structural issues? Ability of economy to grow from under high debt levels? Social stability and strength of political institutions? Strength and will of government coalition? Transparency? Funding access? Capitalization? Liquidity? Size and timing of sovereign exposure to bank liabilities? Transparency of the exposure?

Ireland performs very strongly on some of these ( q y, metrics (liquidity, competitiveness of the economy)… …and less so on others (dependence on international capital markets, strength of banking system)

Ability to devalue currency Reserve currency status

Competitiveness of the economy Ability to deliver on fiscal austerity programs Strength of banking system Assumption of bank sector liabilities by Government

Understanding the Irish Sovereign Crisis
Ireland s Ireland’s banking crisis and sovereign crisis have effectively converged, making the two virtually indistinguishable Whereas Greece’s sovereign crisis was driven by an oversized Government sector (and a liquidity crisis), the heart of Ireland’s sovereign debt i d bt crisis is more closely linked to the State’s decision to directly assume 700 significant 600 financial sector liabilities 500
400 300 200
Source: Bloomberg

Banking Crisis g (6 Key Issues) 1. The Irish banking system is too big 2. Sharp asset and credit 2 Sh t d dit quality deterioration 3. Significant government capital injections
(EUR 45 billion)

Sovereign Crisis g (5 Key Issues) 1. 2010 fiscal deficit of 32%
(12.9% not including bank rescues)

Potential Solutions (5 Key Steps) 1. EUR 80-90 billion from the EFSF/IMF/EFSM
(subject to change)

2. 2 2010 gross debt / GDP of 94% (~70% on net basis) 3. Strained access to capital markets 4. Contagion to Portugal, Spain and Italy 5. 5 Contagion to European financial system

2. Acceleration of fiscal 2 A l ti f fi l adjustment program 3. Continued ECB support
(bond purchases and bank liquidity) li idit )

4. Significant bank liability guarantees
(EUR 147 billion)

4. Clarity on the EU’s planned “Orderly
Restructuring Mechanism”

5. Ireland s bad bank” 5 Ireland’s “bad bank policy (NAMA) crystallized losses 6. Exceptionally high dependence on Central Bank funding

5. Growth from Ireland’s Ireland s competitive economy

10 Year Irish Government Bond Spreads to Germany
2008 2009 2009 2010

100 0 Jan‐08 Mar‐08 May‐08 Jul‐08 Sep‐08 Nov‐08 Jan‐09 Mar‐09 May‐09 Jul‐09 Sep‐09 Nov‐09 Jan‐10 Mar‐10 May‐10 Jul‐10 Sep‐10 Nov‐10

Escalation of the “Irish Crisis” Since October 29
The ebb and flow of public discussion among European leaders since October 29 regarding the possibility of potential losses for bondholders has been a primary driver of the widening in Irish Government bond G tb d yields Uncertainty as to the likelihood and timing of an EFSF bailout has also been a critical factor

Irish Government Bond Yields (October 29 2010 – Present) 29,

2yr Yield 9 8
October 29

4yr Yield

10yr Yield
Peak: November 11

7 6 5 4 3

















October 29, 2010  European Union leaders endorse idea of linking bondholder losses to future bailouts November 12, 2010  EU leaders forced to clarify at G-20 meetings that “existing” bondholders will be protected
Source: Bloomberg


Escalation of the “Irish Crisis” Since October 29
Dates The Irish crisis has escalated rapidly since October 29, when German Chancellor Merkel and French y President Sarkozy endorsed the possibility of bond holder losses on future bailouts Their position was later clarified on November 12th November 11 Key Market Dates Oct. 29 / Nov. 11: Record sell-off in Irish bonds and CDS Nov. Nov 12: Strong rally as worries over restructuring plan dissipate Nov. 16: Global market sell-off as sell off Ireland initially refuses bailout October 29 Details  German Chancellor Angela Markel proposes “orderly restructuring” mechanism requiring bond holders to take haircuts in the event of a sovereign crisis – Investors immediately responded by re-pricing sovereign default risk  Irish Finance Minister Brian Lenihan announces changes to allocate EUR 6 bn of the 4-year EUR 15 bn fiscal plan to 2011 4 year  German Finance Minister Wolfgang Schaueble discloses some detail on Germany’s 2-tier orderly resolution crisis mechanism (with bondholder losses)  French Finance Minister Christine Lagarde publicly supports Germany’s proposal for an orderly resolution crisis mechanism (with bondholder losses)  Ireland’s bank liability guarantee program (ELG) extended to June 2011  Clearinghouse LCH Clearnet increases margin requirements for customers trading Irish bonds (raised again in following week) g p year y yield reaches record levels of 9%  Irish sovereign debt markets spike. The 10 y and Irish CDS widens above 700 bps  Joint statement by France, Germany, Italy, Spain, and UK at G-20 Summit confirming that “orderly restructuring” will not require “existing” bond holder haircuts for debt issued prior to 2013 (investor concerns eased)  Sharp global sell-off across risk asset classes as Ireland refuses initial EU/ IMF/ ECB bailout efforts at EU Finance Minister meetings in Brussels – Declines in global equities, HY bonds, commodities, and currencies  Ireland finally agrees to accept bailout from EU and IMF ( y g p (details to be negotiated g in subsequent weeks)

November 4

November 9

November 10

November 12

November 16

November 21


Assessing the “Magnitude” of Ireland
Key Facts on Ireland (As of Nov 2010)

Relative Economy Size
Country Germany France Italy Spain Netherlands Belgium Austria Greece Finland Portugal % of Euro ‐ 16 27.4% 21.2% 16.9% 11.4% 6.4% 3.8% 3.0% 2.5% 1.9% 1.9% % of Euro ‐ 27 20.5% 15.9% 12.6% 8.5% 4.8% 2.9% 2.3% 1.9% 1.4% 1.4%

Population: 4.6 million GDP: EUR 156.1 billion GDP per capita: EUR 34,907 Ireland % of EU GDP: 1 3% 1.3% Sovereign debt outstanding: EUR 146.2 billion Top b k t t l T 6 banks total assets: ~ EUR 520 billi t billion Top 6 banks total assets / GDP: ~ 3.33x Total bank bailout (Nov 2010): ~ EUR 45 billion Bank liability guarantees (Nov 2010): ~ EUR 147 billion Assets transferred to NAMA (“bad bank”): EUR 53 billion (nominal)

Slovakia Luxembourg g Slovenia Cyprus Malta UK Sweden Poland Denmark Czech Republic Romania Hungary Bulgaria Lithuania Latvia Estonia

0.7% 0.4% 0.4% 0.2% 0.1% NA NA NA NA NA NA NA NA NA NA NA

0.5% 0.3% 0.3% 0.1% 0.0% 14.0% 2.8% 2.7% 1.9% 1.2% 1.0% 0.8% 0.3% 0.2% 0.1% 0.1%

Source: Irish Central Bank. Deutsche Bank Global Markets Research, IMF (October 2010) , Bloomberg, Irish Times (October 2010). EuroStat.

Reason for Optimism: Ireland’s Competitive Economy
With a properly structured bank sector bailout, Ireland’s economy offers a number of compelling reasons to be optimistic about its fiscal turnaround Ireland’s economy g grew annually at a y rate of 6.5% from 1990 to 2007… …and the economy doubled in size during the decade ending 2006 Most importantly, Ireland’s foreign direct investment (FDI) has held up very well during the crisis

Reasons for Optimism on Ireland’s Recovery Ireland s Consideration Fiscal adjustment track record Bank sector loan clean-up Political / social stability Highly educated & flexible workforce Description • • • • • • • • Strong export engine g g Strong Foreign Direct Investment Lowest corporate tax rates in Europe Strong GDP outlook • • • • • • • • Proven track record: Ireland moved early on its fiscal adjustment (began nearly 2 years ago); bodes well for forthcoming EUR 16 billion adjustment On target to have removed EUR 73 billion of bad loans from bank balance sheets via NAMA; only EU country to have moved early on such an initiative Though current coalition Government has narrow majority, Ireland has strong and stable political institutions Has also had strong social cohesion and acceptance of fiscal cuts to date Youngest labor force in Europe (36% under age 25); English-speaking Education system ranks 7th globally for higher education Education expenditures over last 10 years increased 10% per year on average, versus 3% in EU Higher labor productivity vs GDP per person than Germany UK & Japan Germany, EUR 39 billion balance of trade surplus in 2009, and EUR 28 billion as of August 2010 Highest in EU on a per capita basis 5x greater than the OECD average g g EUR 139 and 169 billion in 2008 and 2009, respectively IDA Ireland, agency targeting FDI, says 2010 has been the best in 7 years 12.5% corporate tax rate is lowest among major European economies 25% R&D tax credit Only one of Greece, Portugal and Spain with positive 2011 GDP growth forecast (DB estimate of +1.2% growth in 2011)

Source: Deutsche Bank Global Markets Research.IMF. IDA Ireland: Vital Statistics (Oct 2010), Central Statistics Office (October 2010). Credit Sights.

Reasons for Concern: Contagion
Even with a well structured package for Ireland, the risk of “contagion” is still the greatest area of concern in the global capital markets The “fundamentals” of Greece, Ireland, Portugal, Spain, P t l S i and Italy are very different, but contagion risk is still high

Key Areas of Concern for Contagion   How much further can bank sector losses deteriorate? Will the country continue to deliver on its strong two year track record for fiscal austerity p g y programs? Ability to deliver on its fiscal austerity programs? Is the economy competitive enough to eventually grow out from underneath its debt levels? Will the term of the EFSF loans be extended if needed? Will Portugal be able to improve upon its comparatively poor track record on fiscal austerity (vis-à-vis other peripherals in 2010)? Is the economy competitive enough to eventually grow out from underneath its d bt l it debt levels? How to jump-start largely stalled economic growth? l ? H t j t tl l t ll d i th? Potential for bank sector losses to accelerate significantly? Transparency and market confidence? Has differentiated itself on fiscal policy direction, but how to jump-start jump start largely stalled economic growth? 20% unemployment? Ability to deliver on fiscal austerity programs? Ability to continue to tap capital markets in order to meet its massive 2011 – 2012 funding needs?

    

Key Market Concern In a worst case scenario, are Spain i S i and Italy effectively “too big to fail”?

 

 

Source: Deutsche Bank Global Markets Research.


Key Upcoming Dates
A number of key upcoming events will be important to properly assessing the path ahead

Key Upcoming Dates
Dates Weeks of Nov 22 / 29 November 25 November 30 December 2 December 7       Details Decisions around current Irish negotiations with EU, IMF and ECB? Irish bi-Elections (Donegal) Deadline for the approval of the Portuguese 2011 budget EU Council Meetings: ECB decisions on liquidity regime expected Irish budget meetings Failure to approve the budget would effectively result in a “no confidence” vote in the Government, and could force a national election EU Council Meetings: Draft text for the orderly restructuring mechanism due (critical focus area for international bondholders) Last ECB 6-month and 12-month LTRO’s expire Final ECB weekly MRO tender of the year Portuguese presidential election EU regulators plan to repeat the EU bank stress tests of July 2010

Dec. 16 – 17

December 23 December 28 January 12, 2011 2011

   

Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.


The “I i h C i i ” Th “Irish Crisis”
Section 2

The B ki S t Th Banking System
Section A

The Irish Banking Crisis: 6 Key Issues
From a sovereign crisis perspective, a defining moment of the Irish crisis, in retrospect, may b traced to be t dt the decision by the Irish Government to assume significant liabilities from an oversized banking sector

6 Key Issues •
Issue # 1

The Irish Banking System is Too Big – Top 6 banks assets represent 3.33x GDP

Issue # 2

Sharp bank asset and credit quality deterioration: Phase 1: Construction and commercial real estate loan losses Phase 2: Residential mortgage losses

Issue # 3

Significant government capital injections into banking system: EUR 45 billion to date Significantly more expected in EU / IMF bailout underway

Issue # 4

Significant banking sector liability guarantees EUR 147 billion (EUR 116 billion deposits, EUR 31 billion of bank debt) deposits

Issue # 5

Ireland’s “Bad Bank” policy (NAMA) crystallized losses – Ireland is among the few countries to have actually removed “toxic loans” from the balance sheets of its banking system – Size of the program (EUR 73 billion) and discounts (~58%) have resulted in massive bank sector capital injections

Issue # 6

Exceptionally high dependence on Central Bank funding – Driven by deposit outflows and limited access to capital markets y p p – Record ECB funding: EUR 130 billion (~30% of all ECB funding) – Record Irish Central Bank funding: EUR 20 billion of “exceptional liquidity” extended to Irish banks in Sept and Oct (in addition to ECB funds)

Issue # 1: The Irish Banking System is Too Big
The size of the Irish banking system relative to its economy has been a core issue in this crisis

Key Metrics Ireland’s GDP Ireland’s Top 6 Banks Assets Ireland’s Top 6 Banks Assets / GDP

Size EUR 156 billion ~ EUR 520 billion ~ 3.33x 3 33x EUR 85 billion

By contrast, the nearly 8,000 banks in the United States represent approx 0.85x (or 85%) of U.S. GDP

Estimated Irish Banking System Crisis Losses
(Includes Foreign-Owned Banks in Ireland)

Estimated Bank Losses / G st ated a osses GDP

~ 50%

Bank of Ireland Government Aid Received Government Stake EUR 3.5 bn 36%

Allied Irish Banks EUR 3.5 bn Over 90%
(currently 18% but set to rise)

Anglo Irish Bank EUR 23 bn 100% Nationalized

“The banks were too big a problem for the country. I accept that.” ~ Brian Lenihan, Irish Finance Minister (on Nov 19, 2010)
Note: Ireland’s 6 largest banks used as a proxy for the Irish banking system (Allied Irish Banks, Bank of Ireland, Anglo Irish, Permanent TSB, Irish Nationwide and Ulster Bank). Life insurance assets not included. Source: Central Bank of Ireland.

Issue # 2: Asset and Credit Quality Deterioration
2-Phase 2 Phase Banking Crisis
The senior unsecured ratings of Ireland’s 3 largest banks reflect the public policy decisions of the Irish Government, for now, to preserve the sanctity of the bank senior debt market (and not mandate senior bondholder losses) Phase 1: Construction and developer losses

Phase 2: Residential mortgage losses

Commercial real estate prices declined over 59% since September 2007 Primary driver of EUR 45 billion in bank capital injections to date

Over 40,000 borrowers (5% of Irish mortgage loans) at least 90 days late on payments (as of Sept 30, 2010); represents EUR 7.8 billion of mortgages 25% of outstanding home loans (nearly 200k mortgages) expected to be “underwater” by 2011; some estimates as high as 350k

 Irish residential mortgage debt soared to EUR113 billion in March 2010 from EUR 49 billion in 2003

Irish Bank Senior Unsecured Ratings

Irish Bank CDS
Anglo Irish AIB BoI

A1 / A- (Neg) / A- (Neg)

1200 1000 800

A1 / BBB+ (Neg) / A- (Neg)


600 400 200

Baa3 / BBB / BBB BBB-

Oct‐08 Nov‐08 Dec‐08 Jan‐09 Feb‐09 Mar‐09 Apr‐09 May‐09 Jun‐09 Jul‐09 Aug‐09 Sep‐09 Oct‐09 Nov‐09 Dec‐09 Jan‐10 Feb‐10 Mar‐10 Apr‐10 May‐10 Jun‐10 Jul‐10 Aug‐10 Sep‐10 Oct‐10 Nov‐10

Source: The Irish Times (November 2010), Wall Street Journal (November 2010). DB Global Markets Research. CreditSights.


Issue # 3: Significant Government Capital Injections
Ireland’s EUR 45 billion of capital injections into Irish banks dwarfs the planned EUR 15 billion fiscal adjustment, and dj t t d has exceeded the fiscal capacity of the State (over 30% of GDP)

Total capital injections to date: EUR 45 billion (~ 30% of GDP) p j ( )

Anglo Irish Bank: EUR 29 billion recapitalization to date (split into asset recovery and funding banks with 10-15 year workout) Bank of Ireland: Recapitalized through EUR 3.4 billion equity offering earlier this year (through which Ireland’s national pension fund (NPRF) converted EUR 1.7 billion preferred to equity) Allied Irish: Total capital need of EUR 10.4 billion; approx EUR 3.5 raised, and remainder well underway through asset sales, and potential share offerings and conversions to / with NPRF Irish Nationwide: EUR 5.4 billion re-capitalized; no viable future as independent entity Educational Building Society: EUR 250 million initial recap; subject to sale process Irish Life & Permanent: has not required any government support Gross Fiscal Costs of Banking Crises Bank Bail-outs (% of Home Country GDP)
~18% 18% 11.26%




% of GDP
Thailand Turkey South Korea Ireland Uruguay Malaysia Japan J Finland 0

Anglo Irish Bank  A l I i hB k

1997 2000 1997 2008 2002 1991 1997 1991
10 20 30 40 50

 In total, Ireland has spent ~EUR 45 billion, p or ~30% of GDP, rescuing its banks











Source: Irish Central Bank. Wall Street Journal. Financial Times. DB Global Markets Research.

Issue # 4: Significant Bank Liability Guarantees
Ireland’s decision in September 2010 to extend over EUR 30 billion in bank debt guarantees was a t pivotal moment in the Irish crisis

  

September 30, 2008: Originally introduced as CIFS (Credit Institutions Financial Support Scheme) December 9, 2009: Changed to ELG (Eligible Liabilities Guarantee) June 2011: Originally due to expire on September 29, 2010 First extension to December 31, 2010 Second extension to June 2011 Subject to EU review every 6 months

Expiry Date


EUR 147 billion – EUR 116 billion deposits – EUR 31 billion bank debt issuance

Covered Liabilities

New senior bonds with maturities up to 5 years ( p ) Excludes dated subordinated debt (as of Sept 29, 2010) Corporate and retail deposits Short term bank liabilities and debt securities

  

Source: Irish Finance Ministry. Financial Times. Wall Street Journal.


Issue # 5: “Bad Bank” (NAMA) Crystallized Losses
The National Asset Management Agency
Ireland was one of the only countries during the financial crisis to move quickly around the concept of a “bad bank” to remove the toxic loans from its bank balance sheets Such early action to cleanse the Irish bank balance sheets b l h will pay benefits through the recovery

Program Overview

Purchases to Date

 Established: December 2009  Chief Executive: Brendan McDonagh  Approval / Timing: by European Commission; all loans must be transferred by Feb 2011  Purpose: Bring stability to the banking system by removing impaired loans from balance sheets of individual banks  Domicile of Loans: 33% outside Ireland (6 % Northern Ireland, 21% UK)  F nding Loans paid for with Government Funding: ith Go ernment guaranteed securities (NAMA bonds)  Impact to Sovereign Debt: Treated as offbalance sheet and not included in EuroStat debt metrics

 Target Size: EUR 73 billion (nominal)  Expected average discount rate: 58%  Purchases to Date: EUR 53 billion (nominal)

The creation of Ireland’s “bad bank” (NAMA) has allowed Ireland to crystallize losses in its banking sector much more quickly, and transparently, than most other global banking systems impacted by the financial crisis The United States, for example, pursued a similar initiative for toxic bank loans in 2009, called the PPIP loan program, but ultimately abandoned the planned policy

“If the discount is too light, the banks are enriched as a result. If the discount is too deep, the banks become illiquid. A balance has to be struck.” Brian Lenihan, Irish Finance Minister

Source: National Asset Management Agency

Issue # 6: High Dependence on Central Bank Funding
Irish banks have made record use of both ECB and Irish Central bank funding The acceleration of this need has been driven by an increase in deposit outflows, and limited access to private capital markets funding

Key Issues  Record ECB borrowings (as of Oct. 2010): EUR 130 billion – Irish bank borrowings account for ~30% of total ECB loans (EUR 440 bn) – ECB currently funding ~20% of Irish bank assets – Equal to ~ 83% of Irish GDP – Driven by deposit outflows and limited access to capital markets  Record Irish Central Bank borrowings: EUR 20 billion of “exceptional liquidity” extended to Irish banks in Sept and Oct (in addition to ECB funds)
Irish Bank ECB Borrowings (Jan. – Oct. 2010)
Total ECB loans: EUR 440 bn Ireland Total: EUR 130 bn (~30%)

Figures include funding for both Irish and foreign banks domiciled in Ireland

European Peripheral Euro-Zone Share of GDP vs. Share of ECB Funding
Share of GDP Share of Funding

120 110
EUR bn R


100 90 80 70
Feb‐10 May‐10 Mar‐10 Sep‐10 Jun‐10 Aug‐10 Apr‐10 Oct‐10 Jan‐10 Jul‐10


Spain p







Source: Central Bank of Ireland, Central Bank of Spain, Central Bank of Greece, Central Bank of Portugal, Wall Street Journal (Nov. 2010)

The S Th Sovereign i
Section B

Ireland’s Sovereign Crisis: 5 Key Issues
An accurate assessment of the Irish State’s debt burden necessarily requires more certainty around the liabilities of the Irish banking system Although Ireland is pre-funded through mid-2011, mid 2011 its ability to access the capital markets in early 2011 remains very uncertain From an EU policy perspective, containing the contagion from Spain and Italy is a primary goal

Key Issues • 2010E Fiscal deficit of 32% (12.9% excluding bank rescues) – 2011 Target: Under 10% – 2014 Target: 3% •
Issue # 2

Issue # 1

2010E Gross debt / GDP of 94% (~ 70% on a net debt basis) – Ireland has over EUR 45 billion in cash (EUR 22 billion + SWF assets) – Gross and net debt / GDP projected to peak in 2013

Issue # 3

Highly strained access to capital markets – Sovereign pre-funded through mid 2011 – Suspended remaining 2010 Government bond auctions on Sept 30 – Market access and pricing effectively prohibitive at this time

Issue # 4

Contagion to Portugal, Spain and Italy – The “fundamentals” of Ireland, Portugal, Spain and Italy are very different – M k t expect Portugal to need funds soon after Ireland Markets tP t lt df d ft I l d – Contagion to Spain and Italy would be a “game changer”

Issue # 5

Contagion to the European financial system – Will depend on unfolding of crisis – UK banks have most exposure, followed by Germany and France – Significant ECB exposure as well

Source: DB Global Markets Research. Ireland’s National Treasury Management Agency.


Issue #1: 32% Fiscal Deficit (12.9% Excl. Bank Rescues)
Excluding bank g bailouts, Ireland’s 2010E fiscal deficit is still high at 12.9%, but is projected to come down below 10% in 2011, targeting 3% by 2014

Overview of Ireland s Twin Deficits Ireland’s 2010E Fiscal Deficit (% of GDP)  2010E Including Bank Rescues: (- 32%)  2010E Excluding Bank Rescues: (-12.9%)  Irish Government Fiscal Austerity Plan: 4 years; EUR15 billion; EUR 6 billion frontloaded to 2011  2011E Fiscal Deficit: ( 9 8%) (-9.8%)  2014E Fiscal Deficit: (-3.0%)

2010E Current Account Deficit (% of GDP)  2010E Current Account: (-1.0%)  2011E Current Account: 0.0%  2010 Balance of Payments: EUR 28 billion surplus as of August 2010
Current Account Deficit = + Balance of payments (exports, less imports) + Net factor income (interest; dividends) + Net transfer payments (i.e., foreign aid)
6 4

-8 -13 -18 18 -23 -28

% of GDP

% of GDP

3% limit set by EU Maastricht Treaty

2 0 -2 -4 -6 -8

Excluding bank rescues Including bank rescues

Ireland had a EUR 28 billion balance of payment surplus as of August 2010


-10 10 -12

Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.


Issue #2: Irish Gross Debt to GDP at 94%
Ireland’s debt to GDP (gross and net) are projected to peak in 2013

 Irish government gross debt stands at EUR146.8 bn or 94% of GDP – Approximately 70% on a net debt basis – Ireland has over EUR 45 billion in cash (EUR 22 billion + SWF assets)  The current debt levels, and lack of clarity around Ireland’s bank sector, have created significant “solvency” concerns with investors – Liquidity is not a primary concern as was the case with Greece (pre-funded through mid 2011) 2010E Peripheral Total Debt (EUR bn)

2010E Peripheral Total Debt as % of GDP






EUR 146.8 bn












Source: IMF (October 2010)


Issue #3: Highly Strained Access to Capital Markets
Ireland may be prefunded through mid 2011 (with ~ EUR 46 billion in liquid assets), but the primary concerns around the Irish debt crisis are not liquidity based

Ireland s Ireland’s 10 Year Government Bond Yields (Jan 1 2010 to Present) 1,


Sept 30: Irish government suspends bond sales for the remainder of 2010






Rather, the R th th solvency of the banking system, and the State itself, has been the primary focus of investors, and the primary obstacle to capital markets access

Jan 10 Jan‐10

Feb 10 Feb‐10

Mar 10 Mar‐10

Apr 10 Apr‐10

May 10 May‐10

Jun 10 Jun‐10

Jul 10 Jul‐10

Aug 10 Aug‐10

Sep 10 Sep‐10

Oct 10 Oct‐10

Nov 10 Nov‐10

Ireland’s Favorable Maturity Profile is Not the Primary Focus of Investors
20 15

EUR bn

10 5 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

“In our super-cycle era of Western market leverage, we need capital markets to be fully functioning 24 / 7. Any blockages leave the numerous refinancing entities vulnerable. It just so happens that those currently in need of the most refinancing are Governments.” ~ Jim Reid, Deutsche Bank Macro Strategist (April, 2010)

Source: Bloomberg. Ireland’s National Treasury Management Agency

Issue #4: Contagion to Portugal, Spain & Italy
The risks posed by Greece, Ireland and Portugal (combined 5% of EU) can be well absorbed by EU rescue mechanisms… …however, contagion to Spain y (over 20% % and Italy ( of EU) would raise significant questions on both the willingness and ability of the EU to finance a rescue To be sure, the EFSF would not be sufficiently adequate in size for a bailout of Italy (and some insist the same is true for Spain) Peripheral 10yr Credit Spreads vs. Germany (Oct. 1, 2010 – Present) Peripheral 5yr CDS Spreads (Oct. 1, 2010 – Present)

 Irish 10y spread over Germany reached record levels of 646 bps (and bond yields 9.1%) on November 11, 2010
Italy It l 1200 1000 800 Greece G Portugal P t l Spain S i

 Irish 5y CDS reached record levels of 595 bps on November 11, 2010
Italy It l 1200 1000 800 Greece G Portugal P t l Spain S i



600 400 200 0 1‐Oct 8‐Oct 15‐Oct 22‐Oct 29‐Oct 12‐Nov 5‐Nov

600 400 200 0







“The Irish say they are not Greece. The Portuguese say they are not Irish. The Spanish finance minister last week said that Spain is not Portugal There are no prizes for guessing Portugal. what Italy is not.” ~ Wolfgang Munchau, Editorialist, The Financial Times (Nov 22, 2010)

Source: Bloomberg


Issue #4: Contagion to Portugal, Spain & Italy
Markets strongly expect Portugal will have to follow Greece and Ireland in tapping EU / IMF funds Spain has positively differentiated itself on fiscal policy, but markets are still very focused on this risk To be sure, contagion of the p crisis to Spain and Italy would be a watershed moment in the European debt crisis… …a game changer game-changer This containment has become the primary focus of the EU and ECB

2010E GDP (EUR billi billions) ) % of EU Economy Unemployment Rate 2010 Sovereign Debt 2010 Debt / GDP 2010 Fiscal Deficit 10 Yr Gov’t Yield
(Nov 20, 2010)

Portugal 171.1 171 1 1.4% 10.7% 142.2 83.1% -7.5% 6.7% 416 bps

Spain 1,051 1 051 8.5% 20% 667.2 63.5% -9.0% 4.3% 260 bps

Italy 1,557 1 557 12.6% 8.7% 1,843.6 118.4% -4.9% 4.7% 181 bps

5 Year CDS
(Nov 20, 2010)

Key Questions:    Although the “fundamentals” of Portugal, Spain and Italy are very different from Ireland, how will the markets react in the weeks / months ahead? In particular, how vulnerable are Spain and Italy to contagion? How would the Euro construct survive contagion to these two countries (over 20% of EU)?

Source: Bloomberg as of November 20. DB Global Markets Research, IMF (October 2010), Portugal Finance Ministry, Spain Finance Ministry, Italy Finance Ministry


Issue #5: Contagion to European Financial System
Investors have begun to pay much closer attention on a country’s reliance on international capital markets for funding

Domestic vs Foreign Holdings of Debt by Country vs.  Ireland heavily relies on foreign investors to finance government debt: - A sovereign’s dependency on international capital markets is a critical area of focus in sovereign risk analysis - Japan, for example, has had significant sovereign debt levels for two decades but has largely avoided a funding “crisis” because it has been able to finance its onerous debt levels domestically
Irish Debt Holdings Domestic Foreign g 28% 72%

To this end, Ireland is one of the most y heavily reliant countries on foreign holdings of its public debt (a concern which the EU / IMF bailout should help mitigate)

Foreign holdings

Domestic holdings

A large part of Irish debt is held by the European financial sector including banks, insurance companies, and pension funds

Source: IMF: “Fiscal Exit: From Strategy to Implementation”, OECD

Issue #5: Contagion to European Financial System
Key Details
Similar to the Greece crisis, the European banking system is the primary source of “contagion’ in the f“ t i ’ i th Irish crisis

Top 20 Banks by Net Exposure

 Bank sector exposure to the “Irish crisis” can take many different forms: – Direct losses on loans, bonds and other debt issued – Losses at individual, corporate or sovereign level – Higher costs of capital – Less lending activity g y – Lower profitability via economic impact

Foreign Banks’ Total Exposure to Ireland
(by Nationality as of March 31, 2010) Nationality, 31 (US$ Billions)
UK Germany U.S. France Italy Japan Spain €0 €50 €100 €150 €200 €250

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Bank RBS Allied Irish Banks Bank or Ireland Credit Agricole HSBC Danske Bank BNP Paribas Group BPCE Societe Generale Banco BPI LBBW Bank of Cyprus DZ Bank Postbank Norddeutsche Landesbank WestLB WGZ Bank Caixa Gral. De Depositos Rabobank SNS Bank

Exposure £4.3 bn € 4.1 bn € 1.2 bn € 929 mm $816 mm € 655 mm € 571 mm € 491 mm € 453 mm € 408 mm € 408 mm € 356 mm € 310 mm € 300 mm € 274 mm € 244 mm € 244 mm € 231 mm € 222 mm € 209 mm

Source: Financial Times. Wall Street Journal. Bank of International Settlements.


DB European Peripheral Economic Forecast
Real R l GDP (% Growth) Consumer C (% Growth)
Current Account (% of GDP)

Fiscal Balance Fi lB l (% of GDP)









































Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.


Potential Solutions P t ti l S l ti
Section 3

Potential Solutions: 5 Key Steps
What do capital markets investors want? Transparency: • • • • • • • On bank sector losses (in stress-case scenario) On Government policy decisions, both nationally and at the EU level Agreement among EU countries on path forward On the treatment of bondholders, currently and in the future Markets will re-price risk accordingly On ability to deliver fiscal austerity measures In commitment of opposition political parties, and social willingness to support On all of the above, as much as possible Consistency: • Step # 1: • EUR 80 – 90 billion from the EFSF / IMF / EFSM – For both the sovereign and bank sector Step # 2: Acceleration of Ireland’s EUR 15 billion fiscal adjustment – Credible support from opposition parties critical Step # 3: • Continued ECB support – Sovereign bond purchases / bank liquidity Step # 4: p • EU creation of an “Orderly Restructuring Mechanism” – Clarity around treatment of bondholders, both currently, and in the future Step # 5: • Growth from Ireland’s competitive economy – Maintaining Ireland’s corporate tax rate of 12.5%, and strong FDI flows, will be important to its growth outlook
“There may be a contradiction between the interests of the financial world and the interests of the political world. We cannot keep explaining to our voters and our citizens why the taxpayer should bear the cost of certain risks and not those people who have earned a lot of money from taking those risks.” ~ Angela Merkel, German Chancellor (Nov, 2010)

Potential S l ti P t ti l Solutions: 5 Key Steps K St



Certainty: •

Step # 1: EUR 80-90 billion from EFSF/ IMF/ EFSM
On Nov 21, Ireland’s Prime Minister and EU officials indicated that Ireland will in fact apply for a bailout from the European Union and IMF To be sure, negotiations y underway in Dublin will continue over the coming weeks and be focused on a closer examination of Irish bank balance sheet exposures exposures… …as well as resolving the inherent conflict of interest between the EU s EU’s desire to contain the contagion, and Ireland’s desire to maintain the independence of its economic policy i li

Question What?  

What we do and don’t know (as of Nov 21)? Sunday, Nov 21: Ireland’s cabinet approves application for EU / IMF aid – Negotiations on details should continue for several weeks 2 part bailout package expected (though details not finalized as of Nov 21): 1. Sovereign: Funds for the Sovereign to cover 2011 – 2012 funding 2. Banks: Ireland pushing for “contingency fund” structure to recapitalize its banks (details to be determined by further “stress testing’ of the system”)
EUR 80 – 90 billion expected (less than Greece’s EUR 110 billion) Approximately 1/3 expected to come from the IMF

How much?

 


  

EU/ IMF/ ECB Assessment: Began in Dublin on Thurs, Nov 18 Application: On Nov 21, Ireland’s cabinet approves application for EU/ IMF aid Negotiations on Conditionality: Likely to take weeks; structure of bank contingent capital fund, and Irish corporate tax rate, will be a key focus Review and negotiations underway in Dublin, Ireland At the Irish Central Bank, Ireland’s bond agency, and the Finance Ministry


 

“The European authorities have agreed to our request. The formal process of negotiation will now commence…to be finalized shortly, within the next few weeks.” ~ Brian Cowen, Irish Prime Minister (on Nov 21, 2010)
Source: Deutsche Bank Global Markets Research. Public comments of key Irish and EU officials on Nov 21, 2010.

Step # 1: EUR 80-90 billion from EFSF/ IMF/ EFSM
In addition to potential bilateral loans from the UK and Sweden, the EU has assembled a EUR 750 billion war chest to address the Size EU sovereign crisis (over US $1 Trillion) Approximately 1/3 of Source of g the aid for Ireland is Funding expected to come from the IMF

Sources of EU / IMF Rescue Funds (EUR 750 billion / US$ 1 Trillion)
European Financial Stability Facility (EFSF)  € 440 billion

IMF Loans
 € 250 billion

European Financial Stability Mechanism (EFSM)

 € 60 billion

 Self funding vehicle: - AAA rated - Will not pre-fund (as needed)   Guarantees from EU member states UK not involved in funding


 Expansion of preexisting EU Balance of Payments facility P t f ilit funded with EU bond issuance – Previously used in 2008 for Hungary, Latvia, and Romania – UK is involved in funding

However, use of the EFSF for a significant portion of the package could be viewed as critical to its credibility in the market Terms

 EU Approval: Must have pp unanimous support from all members  Maturity: 3-5 years (expected)  3 year Rate: 3m Euribor + 300 bps  4-5 year Rate: 3m Euribor + y 400 bps  Service Fee: +50 bps

 Subject to IMF g negotiation and conditionality

 EU Approval: Only majority needed (not unanimous as for EFSF)

Requires unanimous EU approval and high conditionality

Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.


Step # 1: EUR 80-90 billion from EFSF/ IMF/ EFSM
Overview of the EFSF
Use of the EFSF for the Irish Crisis will be important for its credibility, and will likely b lik l be well ll received by markets

Details     Headquarters: Luxembourg CEO: Klaus Regling Operational: August 4, 2010 Ratings: AAA/ Aaa/ AAA Expiry: Later of June 30, 2013 (3 years), or at latest maturity date of outstanding loans (up to 5 years) Conditionality: Linked to strict policy agreement pursuant to MoU with the EC Guarantee: Over-collateralized; 20% in excess of total funding volume ECB eligible: Yes Approvals: Requires unanimous support by participating countries  

Funding Self-Funding vehicle: Executed by German Debt Office (DMO), but EFSF is issuer Guaranteed by member states Estimated 1week to raise capital


No pre-funding (funds only upon request) Terms    Maturity limits: None (3 – 5 years expected) No currency limitations (EUR, US$, etc.) Rates: Same as Greece - 3 years: 3m Euribor + 300 bps - 5 years: 3m Euribor + 400 bps

Germany France Italy Spain Netherlands Belgium Austria Portugal g Finland Ireland Slovakia Slovenia Luxemburg Cyprus C Malta Total

€ 122.8 € 92.3 € 81 1 81.1 € 53.9 € 25.9 € 15.7 € 12.6 € 11.4 € 8.1 € 7.2 € 4.5 € 2.1 € 1.1 €09 0.9 € 0.4 € 440.0

   

  

There is no cap on EFSF funds for an Ireland bank sector recapitalization EFSF funds in place are sufficient to cover Ireland, Portugal and Spain, but not Italy The implications of Italy having to tap the EFSF would be “devastating”

Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.

Step # 2: Acceleration of Fiscal Adjustment
Ireland is in the process of accelerating a very aggressive (and IMFlike) fiscal adjustment program that is impressively front-loaded for 2011 Credible support from opposition political parties, and p p , the broader population, will be critical to investor reaction The Nov 4 announced plan, of course, is now subject to EU / IMF conditionality

Nov. 4, 2010: Ireland Proposes f further Fiscal Adjustment Details Announcement Timing:  Late November announcement expected  Inclusion in Dec 7 budget deadline  Subject to EU / IMF conditionality Total Size:  Total Adjustment: EUR 15 billion over 4 years  Breakdown: - EUR 6bn in 2011 (front-loaded) - EUR 9bn 2012-2015 Fiscal Targets:  2011 fiscal deficit: Below 10% by 2011 (from 12.9% currently, excluding bank rescues)  2014 fiscal deficit: Below 3% (as required by EU’s Maastricht Treaty)
Medium deficit (between 5% and 10% of GDP)

Planned Composition of Fiscal Adjustment
Largely Mix (broadly Largely Deficit (2009) Expenditure- equallyRevenuebased based) based High deficit Ireland (above 10% of Japan GDP) Spain UK Portugal Canada France Italy Latvia Lithuania South Africa Turkey Australia Low deficit Germany (below 5% of Korea GDP) Saudi Arabia Mexico China Russia Greece India United States

“We can opt to do this adjustment or we can keep expressing ourselves through anger and the denial of the problem.” Brian Lenihan, Irish Finance Minister
Source: IMF: “Fiscal Exit: From Strategy to Implementation”

Step # 3: Continued ECB Support
Continued ECB support is critical to resolving the Irish and European sovereign debt crisis One of the key goals of the EU/ IMF rescue package, however, will be to reduce Ireland’s bank sector dependence on ECB funding

Overview  Continued ECB support is critical on both: 1. 1 Sovereign debt purchases and purchases, 2. Bank sector liquidity, as needed  Sovereign debt purchases: sharply reduced since June put recent pick-up in Irish bonds  Bank sector liquidity: ECB role has been formidable, especially for Ireland (~30% of ECB total) – Key goal of EU / IMF bailout is to reduce this reliance
130 120 110 100 90 80 70

Irish Bank ECB Borrowings (Jan. – Oct. 2010) Ireland bank funding now accounts for ~30% of ECB funding

EUR bn

Au ug‐10

Ap pr‐10

Ja an‐10

ul‐10 Ju

Ma ay‐10

ar‐10 Ma

Se p‐10

Fe b‐10


ECB Sovereign Debt Purchases Since May 10, 2010
16000 14000 12000 10000 8000 6000 4000 2000 0

Cumulative Total: EUR 65.1 bn


Recent pick-up in Irish bond purchases

ct‐10 Oc

Source: ECB

Step # 4: Clarity on EU’s Restructuring Mechanism
Clarity on the treatment of bondholders is critical to well functioning bond markets The uncertainty on this topic between October 29th and November 12th was y p very disruptive to markets Investors will adjust and re-price risk accordingly (as long as clarity is provided) For now, the confusion around the details and governance of this new plan has created an “overhang” issue in the market

Key Facts on the EU’s “Orderly Restructuring Mechanism”  October 29, 2010: Germany presents a proposal of a 2 tier permanent debt crisis mechanism to be effective by 2013: - Phase 1: Fiscal austerity measures for EU countries struggling with fiscal targets - Phase2: Private creditors would be subject to haircuts  November 12, 2010: Joint announcement at G-20 partially alleviating market concerns: - Mechanism will only apply to new debt issued after 2013 - No forced losses for existing bondholders  December 15 – 16, 2010: Details of a future “Orderly Restructuring Mechanism’ (applicable after 2013) to be disclosed in the European Council meetings Pros and Cons of Orderly Restructuring
Pros  Could potentially improve market confidence: - Assures tax payers that creditors will bear restructuring costs - Cheap pre-funding option for Ireland and Portugal - Proposes a more organized and standardized restructuring process  Could potentially “smoothen” crisis situations by making use of th EFSF ki f the - Less risk of lengthy litigation - Flow of priority financing
Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.

Cons  “Adverse selection”: - “Restructuring premium” would make restructuring more expensive for countries trying to correct fiscal imbalances - Fiscally mismanaged countries might opt to use the mechanism as a cheaper restructuring option  Potential opposition from other governments and private sector for “alternative” measures alternative  Lack of clarity if not designed and executed with consistency

Step # 5: Growth from Ireland’s Competitive Economy
Despite the crisis, Ireland still ranks as one of the most competitive economies in the world To be sure, maintaining its competitiveness will be critical to g delivering on an aggressive fiscal austerity program Importantly, Ireland’s foreign direct investment (FDI) has held up very well during the crisis DB has forecasted positive GDP growth for Ireland in 2011

Ireland’s Position in Global Rankings Rank #1 #4 #4 #6 #7 #7 Competitiveness Ranking For corporate taxes For availability of skilled labor For openness to new ideas For labor productivity For availability of financial skills

European Corporate Tax Rates (by Country)
35 30 25 20 15 10 5 0

Ireland: 12.5% EU Average: 23%

For flexibility and adaptability of people

DB’s 2011E Euro Peripheral Real GDP Growth Estimates
1.5 1.0 0.5 0.0 ‐0.5 ‐1.0 ‐1.5 ‐2.0 ‐2.5 2.5 ‐3.0 1.2 0 0





‐2.7 Greece

Source: Deutsche Bank Global Markets Research (Mark Wall, Thomas Mayer, Gilles Moec. IMD World Competitiveness Yearbook 2010). EuroStat.


Potential U S C it l M k t I P t ti l U.S. Capital Markets Implications li ti
Section 4

Summary Implications for Markets
Markets M k t U.S. Treasury Yields Directional Impact I t

Potential Implications (D P t ti l I li ti (Depending on Crisis Depth) di C i i D th) Currently being driven by 3 macro themes: 1) Federal Reserve policy and QE2 2) China tightening and inflation risk 3) European sovereign credit risk Impact of Irish and European Debt Crisis: If crisis accelerates, directional impact on UST yields will be decidedly downward as investors seek “safe haven” Currently: marginal impact (so far); volatility has put a soft lid on volumes, and introduced a volatility premium into pricing (albeit limited impact so far) – Week of Nov 15th was expected to be a blockbuster US$ issuance week – Ended up being the lowest volume week of the (3 week) month so far (US$15 billion of issuance was a sizeable drop from the nearly US$24 billion the prior week) Potential: If crisis accelerates, could be significant (U.S. bond markets effectively closed the entire week of May 3rd as the Greece credit crisis peaked); contagion to Spain and Italy would be a “game changer” Credit Spreads: Some upward pressure, but limited so far – US$ market in 2010 has been driven largely by favorable technicals (record fund flows) – If crisis accelerates, that can change quickly New Issue Premiums: Some upward pressure, but minimal so far Impact of Irish crisis already evident in November – As of Sept 30, non-U.S. issuers accounted for ~ 35% of US$ IG bond market issuance – However, volumes from Europe have been down sharply in November

US$ Bond Market

Yankee Bank Issuance (US$ Market)

“The two main concerns [in markets] are the sovereign debt crisis in Ireland and the inflation bubble risk in China. Global growth depends on the resolution of those two problems.” ~ European Asset Manager (November 19, 2010)

Summary Implications for Markets
Markets U.S. Banks
Directional Impact
 

Potential Implications (Depending on Crisis Depth) Direct Exposure: $114 billion of direct exposure to Ireland (loans, bonds and other debt issued by Irish companies, individuals and governments) More indirect impact: U.S. bank spreads still very vulnerable to exogenous shocks at this time; contagion effect; higher cost of capital Full impact will depend on extent of the contagion Sovereign Market: Stabilization of this sector is critical to the overall market Corporates: European corporate credit markets have proven to be remarkably resilient as compared t th peak of th G k crisis i M 2010 d to the k f the Greek i i in May – The blue-chip iTraxx Europe index of 125 investment grade corporates (as well as the Europe Crossover index of 50 largely non-IG names) has remained resilient as the Irish crisis has peaked – Corporate credit curves have also steepened (bullish sign showing comfort on front end) Financials: Significantly more vulnerable, but market still very much open for “stronger financial players” – Mid-caps and second tier financial names have been more impacted Public Policy Issues: Critical to get market clarity on the issue of “bail-ins” (creditor losses on rescues) very soon in order to improve investor risk appetite ) y p pp UK Bank Exposure: US$ 222 billion of direct exposure to Ireland (loans, bonds and other debt issued by Irish companies, individuals and governments) – German Bank Exposure: US$ 206 billion – French Bank Exposure: US$ 86 billion – It li Italian Bank Exposure: US$ 29 billi B kE billion – Spanish Bank Exposure: US$ 16 billion Cost of capital: Strong upward pressure if crisis accelerates; higher debt costs and increased equity capital needs

European IG Bond Markets

  

European Banks

Summary Implications for Markets
Markets Commodities (Oil, Other)
Directional Impact
  

Potential Implications (Depending on Crisis Depth) Impact from acceleration of Irish crisis in November has been limited Will increase markedly if contagion not contained Oil and other commodity asset classes will experience downward pressure on “Risk Off” Risk Off th when Ireland initially refused EU rescue days in the market (such as November 16 loans) Has and will continue to be a “safe haven” for investors when the Euro crisis accelerates Has also been an important market for investors to hedge sovereign risk generally “Relief rally” expected on the back of the Irish application for EU / IMF aid on Nov 21 (and likely to track the pace of negotiations in subsequent weeks) As the crisis accelerated in early November, the Euro moved down sharply from 1.43 to 1.35 – Not nearly as strong a decline as with the Greece crisis in May – Generally, if the contagion accelerates, downward pressure on the Euro has the p potential to be q quite strong g Contagion to Spain and Italy would be a “game-changer” – Potentially “too big to fail”? – Would raise questions about the longer term viability of the Euro


 

Euro / US$ Exchange Rate

 


The VIX Volatility Index
VIX Daily Closing Values (Sep 1 2008 – Present) (Sep. 1,
The VIX has not returned to the 80 levels of the Lehman bankruptcy, but did reach as high as 40 in May during the peak of the Greece crisis For now, the index has remained largely contained as the Irish crisis has accelerated in November 2010

 

Greece Crisis Peaks (Week of May 3rd): VIX jumped a breathtaking 85% Irish Crisis Accelerates (Oct 29 – Nov 16): VIX jumps ~ 5%, but then rallies to lower levels as details of Ireland’s reluctant acceptance of EU / IMF aid begins to emerge

90 80
Lehman Bankruptcy

70 60 50 40 30 20 10
Aug‐09 Apr‐09 May‐09 Apr‐10 May‐10 Feb‐09 Mar‐09 Feb‐10 Mar‐10 Aug‐10 Jan‐09 Jun‐09 Jul‐09 Jan‐10 Sep‐09 Oct‐09 Jun‐10 Jul‐10 Nov‐08 Dec‐08 Nov‐09 Dec‐09 Sep‐10 Oct‐10 Nov‐10

Greece Crisis

Irish Crisis

Source: Bloomberg


Impact on the Euro
To be sure we sure, expect a relief rally in the Euro following the Ireland EU/ IMF rescue package However, the scope and pace of contagion will be critical to any longer term assessments t

Overview (as of Nov 21, 2010) 21

 Despite a strong rally since September, the Euro declined sharply in November as the Irish Crisis accelerated: - Irish Crisis High: On Nov 4, Euro /US$ hit its highest point since January ($1.43) - Irish Crisis Low: On Nov 16, following Ireland’s refusal to tap EFSF funds, Euro/ US$ closed at a 3 month low (1.35)  What to expect from here? – Relief rally expected coming out of the Irish bailout announcements of Nov 21 – The ability to “contain the contagion” of the crisis will be critical to any forecasts from here
Euro/USD Spot vs. Euro/USD Purchasing Power Parity (PPP) (January 1, 2010 – Present)

The Euro has traded around 20% above its purchasing power parity since January

Euro/ USD Euro/ USD 1.5 1.4 1.3 1.2 1.1


PPP 20% Band PPP+‐20% Band

‐20% 20%

Irish Crisis Accelerates
1 0.9 0.8 Jan‐10 Feb‐10 Mar‐10 Apr‐10 May‐10 Jun‐10 Jul‐10 Aug‐10 Sep‐10 Oct‐10 Nov‐10

Source: Bloomberg

Impact on the Euro
We expect a relief rally in the Euro following the Ireland EU/ IMF rescue package… but …but conclusions over the medium to longer term must consider a range of factors

Dual Views Over the Future of the Euro
Bullish View  Market has priced in the EFSF: y y p - EFSF is now ready and fully operational - After unofficial rumors surfaced on November 12th about an Irish bail-out, European credit markets rallied  QE2 announcement impact: - The Fed will continue to hold strong behind this policy, despite global market criticism  Irish fiscal adjustment plan: - Plan will be approved by Dec 7, and will be a turning point in the balancing the deficit  G 20 announcement regarding orderly G-20 t di d l restructuring: - Confirmed that creditors will not take hits on debt issued prior to 2013  More transparent European market: - Orderly restructuring and fiscal adjustments could be perceived as a more transparent and potentially more stable market in the mid to long term  Portugal may need EFSF funds, but crisis will be contained from impacting Spain and Italy  European economy will stabilize, and embark on a steady path of GDP growth (albeit slower than historical cycles) Bearish View  The EFSF has not been proven: - Significant uncertainty as to its capacity beyond g y p y y Ireland and Portugal  Contagion effect to euro financial system: - Possible contagion effect across European peripherals, leading the market concerns over further use of the EFSF by Spain or Italy - EFSF would not be capable of financing Spain or Italy if needed, leading to crisis in the Euro zone  European financial system, the primary credit provider in the European economy, will be ( g g q y stressed (with drag on lending and liquidityprovider activities)  Market reaction to December 16th: - Details on the orderly restructuring mechanism disclosed in December might not be positively viewed by the market y  Possible failures of fiscal adjustment: - Fiscal adjustment of EUR 15 bn is only a fraction of the increasing Irish bank bail-outs - Greece, Portugal, Spain and Italy have long and challenging fiscal adjustment roads ahead


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