All Sections Combined 101151513

FIXED INCOME RESEARCH | MONDAY, MARCH 17, 2008
A Time for Calm

RELATIVE VALUE
The market overshoot/risk paranoia in the

dollar, commodities, yield curves, and
high-quality spread sectors is greatly
overdone, but not done. By contrast,
monetary,
fiscal,
and
legislative
intervention is neither overdone nor done.
This market-policy contradiction suggests
further tactical portfolio defensiveness
(lowering recommended HY allocation
from 5% underweight to -15%) and
incrementally more exposure to U.S.
agency MBS, which we increased from
3% underweight to 5% overweight
following the Term Securities Lending
Facility proposal. We also reviewed past
business cycles to estimate that long-term
yields, spreads, and equities are only
halfway to their cyclical turning points.
EQUITY STRATEGY
17
In the current environment, good news

comes at a premium. We are thus a little
surprised that the market has not responded
more positively to some of the recent
data in Japan, at least on a relative basis. In
no sense can we describe the economic
outlook there as good, but with
expectations already low and the speed
with which sentiment regarding the U.S.
economy has deteriorated in recent weeks,
we think a better relative performance is
justifiable. We remain Overweight.
ECONOMICS
20
The Fed is taking steps to improve market

liquidity. We expect it to keep slashing
rates, too. In Europe, we are now alert to
the risks of a sudden and sharp drop in

growth. In Japan, the risk of recession is
growing, but there is still a chance that
it can be avoided.
POLITICAL ANALYSIS
37
Global infrastructure investment is being

spurred by recently abundant selffinancing available in developing regions
and two decades of meager spending in
the U.S.
COMMODITIES
39
Investors often view commodities as

purchasing power protection, and recent
price movements against inflation
expectations support that view. Yet real
price and return calculations show an often
tenuous relationship between commodities
and inflation.
CURRENCIES
42
The deterioration in financial markets

remains a big upside risk to the yen,
especially since the Japanese have not yet
retreated from global capital markets.
That said, the effect of yen strength and
Nikkei weakness on Japans economy will
be significant.
INTEREST RATES STRATEGY
45
The Feds next steps, besides easing, are

likely to focus on broker-dealers, could
possibly include other AAA assets, but will
likely continue to be primarily financing
rather than purchase transactions.
SECURITIZED STRATEGY
77
Last week was another turbulent,

headline-driven week in the mortgage
market. The Feds TSLF program
alleviated some concerns about financing;
but news of hedge fund defaults and bank
liquidity issues weighed on the market.
Given continued uncertainty, we think it is
hard to have strong conviction on the
mortgage basis. In CMBS, spreads
widened in volatile trading action; given
the volatility, we explore new trades in
index swaps and CMBX.
CREDIT STRATEGY
106
We believe that the Fed will eventually

win the liquidity battle, but with
fundamentals continuing to deteriorate,
we expect to move from a liquidity crisis
to more fundamental solvency concerns,
as many entities remain overleveraged.
We thus expect the deleveraging to
continue. We also discuss the potential
influence of CLOs on secondary trading
in the leveraged loan market.
PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 118
Contents
GLOBAL RELATIVE VALUE
COMMODITIES
SECURITIZED STRATEGY
A Time for Calm .............................. 8
An Inflation Hedge,
but for How Long? .........................39
MBS
EQUITY STRATEGY
Can Japan De-Couple? ................ 17
CURRENCIES
Can Someone Hit the Brakes? ......77

Mortgage Leveraged Portfolio .......79
Ongoing Risk Aversion

Should Sustain Yen Rally ..............42
ABS
Global Economics
INTEREST RATES STRATEGY
Liquidity Lesson ............................ 20
U.S. Interest Rates Strategy
Liquidity Concerns and

Asset Liquidations Lead
Resi-Credit Sell-off ........................86
U.S. Economics
How Deep Are

the Feds Pockets? ........................45
HEL: Subprime Performance in

a Negative HPA Environment........87
The Week Ahead .......................... 25
Treasury Inflation-Protected
Securities: Are Breakevens
Understating Inflation?...................55
ABX: Update on the February

Remittance Performance...............88
European Economics
Agencies:
Widespread Underperformance.....58
Residential Credit:
Updated Loss Expectations
across Residential Credit ..............89
European Interest Rates Strategy
ABX: Relative Value Views

and Credit Leveraged Portfolio......90
Its Always Fair Weather ................62
Consumer ABS: Auto, Credit Cards,

Student Loans ...............................91
Euro Relative Value:

U.K. Swap Spreads: Wild Thing ....66
CMBS
ECONOMICS
Street-Fighting Man ...................... 22
Re-coupling with Decoupling ........ 28

Japan Economics
Resilience ..................................... 31
Asia Ex-Japan Economics
Weekly Review: Fed Actions/S&P

Comments Spark an ABX Rally.....85
Australia: Mind the Gap ................ 34
Sterling Strategy:
Surprising Resilience .................69
Market Monitor ..............................92
POLITICAL ANALYSIS
Euro Area Inflation Strategy:

Youve Got to Believe ....................71
CMBX Update ...............................98
Building on an Infrastructure
Finance Strategy........................... 37
Asian Interest Rates Strategy
Trade Idea in Index Swaps............96
European Structured Products

Rally Causes
Several Distortions ........................75
Technicals Turn
Even More Negative.................... 104
News In Brief ............................... 105
CREDIT STRATEGY
U.S. Credit
Markets neither Shocked nor
Awedbut Hope Endures ........... 106
The CLO Factor in a
(Dis-) stressed Loan Market ........ 108
REGULARS
Market Data ................................. 115
Calendar ...................................... 116
Lehman Brothers | Global Relative Value
Global Fixed-Income Asset Allocation

Summary Recommendation, as of March 14, 2008
Option-Adjusted Duration
100%
Tracking Error Volatility

22 bp
Spread Duration
95%
Global Aggregate Portfolio

Percent of Market Value by Duration Range
Sector
0-2
2-4
4-7
7-9
9+
Contribution to
Total
Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Index
Rec.
Treasury
8.66 7.54 11.71 5.95 11.71 15.60 6.78 6.70 9.76 10.87 48.62 46.66
Agency
2.27 1.89 2.62 3.30 2.65 6.11 1.15
1.17 0.90
9.86 12.20
Credit
2.65 5.02 5.71 5.78 6.51 6.82 2.59 0.25 3.22 3.16 20.67 21.03
US Mortgage
3.42
7.50 8.57 2.49 3.64
13.42 12.21
ABS / CMBS
0.17 0.51 0.40 0.76 0.88 0.51 0.29
0.15 0.23
1.89
2.00
Collateralised (Pfandbrief) 1.13 3.35 1.93 1.57 1.59 0.96 0.57 0.00 0.31 0.02
5.53
5.90
Total
18.29 18.31 29.87 25.92 25.83 33.64 11.39 6.95 14.62 15.18 100.00 100.00
% Over (+)/Under(-) Weight
-13
30
-39
% Over (+)/
% Over (+)/
Under (-)
Option-Adj. Duration Spread Duration Under (-)
Weight
Weight
Index Rec. Diff. Index Rec. Diff.
2.92 3.07 0.14 0.00 0.00 0.00
-4
0.48 0.55 0.07 0.48 0.57 0.08
24
17
1.14 1.02 -0.12 1.13 1.04 -0.09
2
-8
0.41 0.42 0.02 0.46 0.47 0.00
-9
1
0.10 0.07 -0.03 0.10 0.08 -0.03
6
-26
0.23 0.14 -0.10 0.24 0.14 -0.10
7
-41
5.29 5.27 -0.01 2.42 2.29 -0.13
Global Aggregate Index by Currency of Issuer
U.S. Dollar
Euro
Japanese Yen
British Pound
Canadian Dollar
Australian Dollar
New Zealand Dollar
Swedish Krona
Danish Krone
Norwegian Krone
Singapore Dollar
Korean Won
South African Rand
Hong Kong Dollar
Chile Peso
Mexican Peso
Slovakia Koruna
Hungarian Forint
Czech Koruna
Polish Zloty
Taiwan Dollar
Malaysia Ringgit
Total
Percent
Mkt. Val.
37.2
31.9
17.7
5.3
2.6
0.5
0.1
0.7
0.4
0.2
0.2
1.3
0.2
0.0
0.0
0.3
0.0
0.2
0.2
0.4
0.4
0.2
100.0
Global Aggregate Index

No. of
Mod. Adj.
Issues
Duration
5,408
4.45
2,731
5.52
1,556
5.89
913
7.94
457
7.00
139
3.82
19
3.90
50
3.58
37
4.54
10
3.96
20
5.21
157
3.39
45
5.26
1
1.36
4
3.41
17
5.13
7
3.98
21
3.57
16
5.77
14
3.82
68
6.97
25
4.84
11,715
Contrib. to
Duration
1.66
1.76
1.04
0.42
0.18
0.02
0.00
0.03
0.02
0.01
0.01
0.04
0.01
0.00
0.00
0.02
0.00
0.01
0.01
0.02
0.03
0.01
Percent
Mkt. Val.
38.7
35.1
13.3
5.6
2.3
0.8
0.1
0.6
0.5
0.1
0.1
1.1
0.2
5.29
100.0
5.29
0.0
0.3
0.0
0.2
0.1
0.3
0.4
0.2
Global Aggregate Portfolio

No. of
Mod. Adj.
Contrib. to
Issues
Duration
Duration
56
4.40
1.71
34
5.65
1.98
7
5.94
0.79
14
8.10
0.45
3
6.82
0.16
1
2.89
0.02
1
4.18
0.01
3
3.41
0.02
5
3.39
0.02
1
1.63
0.00
3
4.74
0.01
3
3.20
0.03
1
2.11
0.00
0.00
1
5.45
0.00
1
8.82
0.02
1
8.42
0.00
1
4.15
0.01
1
4.69
0.01
1
1.85
0.01
1
6.37
0.02
1
4.52
0.01
140
5.27
Japanese Yen
Australian Dollar
New Zealand Dollar
Singapore Dollar
Korean Won
Hong Kong Dollar
Taiwan Dollar
Malaysia Ringgit
85.1
2.8
0.5
0.9
7.4
0.0
2.3
1.0
Option-Adjusted
Duration: 101%
Asia-Pacific Aggregate Index

No. of
Mod. Adj.
Contrib. to
Issues
Duration
Duration
5.82
4.07
4.06
4.65
3.31
1.70
7.36
4.79
4.95
0.11
0.02
0.04
0.24
0.00
0.17
0.05
Asian-Pacific Aggregate Portfolio

Percent
No. of
Mod. Adj.
Contrib. to
Mkt. Val.
Issues
Duration
Duration
69.0
3.5
0.3
1.1
8.1
0.0
8.7
9.3
22
3
1
2
2
1
1
1
5.83
1.15
3.79
1.71
4.34
2.10
7.21
5.17
4.02
0.04
0.01
0.02
0.35
0.00
0.63
0.48
Total
100.0
1,862.0
5.59
5.59
100.0
33.0
Market Value and duration contribution statistics reflect values as of the prior business day.
Overweight/underweight percentages highlighted in shaded area represent current date recommendations.
5.55
5.55
March 17, 2008
1,476
125
14
20
129
2
70
26
4
10
-24
5
-14
44
50
-18
14
-28
-16
-17
-15
-100
-33
-13
-23
31
-18
-19
-13
-21
5.27
Asian-Pacific Aggregate Index by Currency of Issuer
Percent
Mkt. Val.
% Over (+) /
Under (-)
Weight
% Over (+) /
Under (-)
Weight
-19
26
-38
18
10
24
280
812
U.S. Fixed-Income Asset Allocation

Spread Duration
99%
103%
U.S. Aggregate Core Portfolio

0-2
Index
5.92
3.70
12.56
0.45
0.27
2.30
25.20
Sector
Tsy
Agy
Mtg.
CMBS
ABS
Credit
Total
2-4
Index
4.77
2.53
19.86
1.18
0.32
5.93
34.59
Rec.
2.40
5.86
17.62
0.00
0.39
0.96
27.23
% Over (+)/
Under(-) Weight
Rec.
5.40
1.78
21.30
0.00
0.32
9.51
38.31
4-7
7-9
9+
Index
Rec. Index
Rec. Index Rec.
5.78
5.00 2.38
3.11 3.56 3.25
2.10
1.03 0.73
0.00 0.57 1.44
6.57
2.05 0.00
0.00 0.00 0.00
2.95
3.91 0.63
0.00 0.00 0.00
0.17
0.17 0.07
0.00 0.01 0.00
6.60
8.61 3.08
0.64 5.04 5.55
24.16 20.76 6.88
3.75 9.17 ####
11
-14
-45
Recommended Portfolio by Duration Range
12
11
12
Portfolio Allocation by Asset Class
% Relative
to Index
20
Total
Index
Rec.
22.41
19.16
9.62
10.10
38.99
40.97
5.21
3.91
0.83
0.87
22.94
25.26
100.00 100.00
Contribution to Spread Duration

% Over (+)
% Over (+)
/ Under
/Under(-)
Option-Adj. Dur.
Spread Dur.
(-) Wght Index Rec. Diff. Index Rec. Diff.
Wght
1.15 1.29 0.14 0.00 0.00 0.00
-15
0.34 0.39 0.04 0.35 0.38 0.03
5
9
1.08 0.84 -0.24 1.22 1.28 0.06
5
5
0.25 0.25 0.00 0.25 0.20 -0.05
-25
-19
0.03 0.02 0.00 0.03 0.03 0.00
5
5
1.44 1.48 0.04 1.44 1.48 0.04
10
3
4.31 4.27 -0.04 3.29 3.37 0.08
3
% Relative
to Index
15
10
5
-20
-14
-15
-40
-45
2-4
4-7
7-9
Tsy
>9
Contribution to OAD by Asset Class
Agy
Mtg.
Passthrghs
CMBS
ABS
Credit
Contribution to Spread Duration by Asset Class
99%
% Relative
to Index
12
15
-25
-30
-60
0-2
-15
13
2
Spread Duration
103%
-1
0
-1
% Relative
to Index
15
9
10
Credit
Total
0
-5
-15
-10
-18
-15
-22
-20
-30
Tsy
Agy
Mtg.
CMBS
Passthrghs
ABS
Credit
Total
-19
-25
Agy
Mtg.
CMBS
ABS
March 17, 2008

Spread Duration
99%
103%
U.S. Aggregate Core Portfolio

Approx.
Maturity/ Dura.
T-Bills/ 0-1 yr 2 yr/ 1-2 yr

3 yr/ 2-3 yr
4 yr/ 3-4 yr
Index Rec. Index Rec. Index Rec. Index Rec.
Treasury
0.33 0.00 5.85 0.00
2.64 0.00 2.65
0.00
Agency
1.15 0.69 2.61 7.85
1.69 0.00 1.30
0.00
Mtg. Pass-throughs 0.30 1.94 2.89 15.13
4.43 4.75 13.03
4.30
CMBS
0.01 0.00 0.46 0.00
0.55 0.00 0.67
0.00
ABS
0.03 0.05 0.29 0.27
0.25 0.66 0.11
0.23
Credit
0.15 0.00 2.20 0.92
2.60 2.72 3.23
5.30
Total
1.97 2.68 14.30 24.17 12.16 8.13 20.99
9.83
% Over (+)/
Under(-) Weight
36
69
-33
Percent of Market Value

5-6 yr/ 4-5 yr 6-10yr/ 5-7 yr 10-20 yr/ 7-10 y20-30 yr/ 10 +
Total
Index
Rec. Index Rec. Index
Rec. Index Rec. Index
Rec.
1.67
0.00
3.79 0.00 3.05
0.00 2.76 0.00 22.74
0.00
0.63
3.26
1.37 0.00 0.75
0.00 0.48 0.00
9.98 11.80
13.36 18.78
4.41 0.00 0.00
0.00 0.00 0.00 38.42 44.90
0.58
0.00
2.44 12.72 0.91
0.81 0.00 0.00
5.62 13.53
0.07
0.40
0.11 0.04 0.05
0.00 0.01 0.00
0.92
1.65
2.32
5.02
4.34 6.26 2.79
0.58 4.69 7.32 22.32 28.12
18.63 27.46 16.46 19.02 7.55
1.39 7.94 7.32 100.00 100.00
-53
47
16
-82
% Over
(+)/Under
Wght
-15
5
5
-25
5
10
-8
Corporate Sector Recommendations (spread duration contribution)

Aaa-Aa
Index
Rec
Diff.
Index
A
Rec
Diff.
Index
Baa
Rec
Spread Duration
0-3
3-5
5-7
7-10
10+
Total
0.03
0.07
0.09
0.08
0.22
0.49
0.06
0.08
0.02
0.02
0.13
0.30
0.03
0.01
-0.06
-0.06
-0.09
-0.18
-37
0.02
0.08
0.10
0.07
0.24
0.50
0.01
0.17
0.13
0.02
0.03
0.36
-0.01
0.09
0.03
-0.05
-0.21
-0.15
-29
0.02
0.08
0.09
0.07
0.23
0.50
0.02
0.19
0.20
0.00
0.70
1.11
Sector
Financial
Utility
Industrials
Non-Corp.
Total
0.21
0.00
0.06
0.12
0.39
0.07
0.00
0.04
0.20
0.30
-0.14
0.00
-0.01
0.07
-0.09
-22
0.18
0.04
0.23
0.03
0.48
0.05
0.00
0.30
0.00
0.36
-0.13
-0.04
0.07
-0.03
-0.13
-26
0.05
0.09
0.33
0.03
0.50
0.09
0.21
0.67
0.14
1.12
'% Over (+)

/Under(-)
Index
Total
Rec
0.00
0.10
0.12
-0.07
0.47
0.62
125
0.06
0.23
0.27
0.23
0.69
1.48
0.08
0.43
0.36
0.04
0.86
1.78
0.02
0.20
0.08
-0.18
0.17
0.29
20
31
86
31
-81
25
20
0.03
0.12
0.35
0.11
0.61
122
0.45
0.14
0.62
0.18
1.38
0.21
0.21
1.02
0.34
1.78
-0.24
0.08
0.40
0.16
0.40
29
-54
56
66
84
29
Diff.
Diff.
Weight
March 17, 2008

MBS Sector Recommendations (spread duration contribution)
Index
Program & Price
% Mkt.
Val.
Recommend.
% Sprd
Dur.
% Mkt.
Val.
% Sprd
Dur.
%Over (+)/
Under(-)/Wght
Difference
% Mkt.
Val.
% Sprd
Dur.
% Mkt.
Val.
% Sprd
Dur.
GNMA
< 98
98 to <102
102 to <106
106+
0.64
2.17
0.57
0.01
0.03
0.09
0.02
0.00
0.00
4.76
0.00
0.00
0.00
0.20
0.00
0.00
-0.64
2.59
-0.57
-0.01
-0.03
0.12
-0.02
0.00
-100
119
-100
-100
-100
134
-100
-100
< 98
98 to <102
102 to <106
106+
0.03
0.08
0.00
0.00
0.001
0.003
0.000
0.000
0.00
0.15
0.00
0.00
0.00
0.00
0.00
0.00
-0.03
0.07
0.00
0.00
0.00
0.00
0.00
0.00
-100
88
-
-100
92
-
3.50
0.14
4.91
0.21
1.41
0.07
40
51
Conventional 30-year
< 98
98 to <102
102 to <106
106+
10.64
13.51
1.39
0.01
0.46
0.49
0.04
0.00
1.75
18.12
12.12
0.00
0.08
0.69
0.35
0.00
-8.89
4.61
10.73
-0.01
-0.38
0.20
0.30
0.00
-84
34
772
-100
-83
40
669
-100
Conventional 15-year
< 98
98 to <102
102 to <106
106+
2.56
2.93
0.00
0.00
0.09
0.09
0.00
0.00
0.00
3.00
0.00
0.00
0.00
0.09
0.00
0.00
-2.56
0.07
0.00
0.00
-0.09
0.01
0.00
0.00
-100
2
-
-100
8
-
31.04
1.18
34.99
3.95
0.03
13
0.18
0.00
0.00
-0.18
0.00
30-year
15-year
GNMA Summary
Fannie Mae and Freddie Mac
Conventional Summary
Balloons
Total Pass Throughs
1.21 #
0.00
34.72
1.32
39.92
1.41
5.20
0.09
15
CMBS
5.63
0.28
13.53
0.88
7.90
0.60
140
212
Total
40.35
1.60
53.45
2.29
13.10
0.69
32
43
MBS Market Value by Coupon (%)

Total
<4.5
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
8.5
9.0
GNMA 30
4.76
2.97
1.79
GNMA 15
0.15
0.15
FHLM 30
15.26
7.95
1.82
5.48
FHLM 15
1.29
0.76
0.27
0.26
FNMA 30
16.73
1.75
7.54
0.81
6.63
FNMA 15
1.70
0.32
0.78
0.60
Core MV [%]
U.S. Aggregate MV [%]

GNMA 30
3.37
0.06
0.58
1.15
1.01
0.41
0.12
0.03
0.01
GNMA 15
0.10
0.01
0.03
0.05
0.02
0.01
FHLM 30
10.54
0.01
0.36
2.66
3.83
2.68
0.81
0.15
0.04
0.01
FHLM 15
2.59
0.29
0.89
0.82
0.38
0.18
0.04
FNMA 30
14.90
0.40
3.37
5.49
3.86
1.32
0.37
0.08
0.02
FNMA 15
2.88
0.22
0.88
0.97
0.49
0.27
0.05
March 17, 2008

Spread Duration
99%
102%
U.S. Dollar Core Plus

0-2
Index Rec.
Tsy
5.17 1.96
3.23 5.88
Agy
Mtg. Passthroughs 11.01 19.08
CMBS
0.44 0.00
ABS
0.23 0.39
Corporates
IG
2.94 1.15
HY
0.38 0.65
EMG
0.10 0.00
Municipals
0.00 0.00
Total
23.50 29.11
% Over (+) /
Under (-) Weight
24
Sector
2-4
Index
Rec.
4.17
3.78
2.21
1.64
17.48 13.00
1.14
0.10
0.28
0.22
4-7
Index Rec.
5.04 4.85
1.83 0.00
5.76 1.23
2.87 3.67
0.15 0.15
6.63
1.39
0.21
0.00
33.51
10.54
1.54
0.82
0.00
31.63
7.58 9.48
2.77 2.55
0.63 0.21
0.00 0.00
26.63 22.12
-6
-17
7-9
Index Rec.
2.08 3.08
0.64 0.00
0.07 0.00
0.57 0.00
0.06 0.00
3.10
0.22
0.18
0.00
6.92
9+
Index Rec.
3.10 3.55
0.49 1.29
0.01 0.00
0.00 0.00
0.01 0.00
0.71
0.06
0.00
2.00
5.84
4.96
0.29
0.58
0.00
9.44
-16
5.87
0.00
0.59
0.00
11.30
Total
Index
Rec.
19.56 14.21
8.39
8.81
34.34 33.31
5.02
3.77
0.72
0.76
% Over (+)
/ Under(-)
Weight
Index
-22
1.01
5
0.30
5
0.99
-25
0.24
5
0.02
25.22 27.74
5.04
4.79
1.70
1.62
0.00
5.00
100.00 100.00
10
-15
-5
-
1.48
0.23
0.12
0.00
4.39
Contribution to
OAD
Rec.
1.17
0.29
0.75
0.25
0.02
Diff.
0.17
-0.01
-0.24
0.00
-0.01
1.56
0.20
0.09
0.00
4.34
0.08
-0.03
-0.02
0.00
-0.05
Spread Duration
Index Rec. Diff.
0.00 0.00 0.00
0.30 0.32 0.02
1.13 1.19 0.06
0.24 0.19 -0.05
0.02 0.03 0.00
1.45
0.23
0.10
0.00
3.48
1.53
0.20
0.09
0.00
3.55
%
Over
Weight
5
5
-20
7
0.08
-0.03
-0.01
0.00
0.06
6
-15
-10
-
20
Recommended Portfolio by Duration Range
Portfolio Allocation by Asset Class
% Relative
to Index
30
24
20
% Relative
to Index
15
20
10
5
10
-5
-15
-15
-6
-10
-22
-20
0-2
2-4
-17
4-7
Duration Range
9+
Tsy
Contribution to OAD by Asset Class
-10
-12
-24
Agy
Mtg. CMBS
Passthroughs
-20
-22
-20
-25
ABS
IG
HY
-10
-15
-20
Tsy
Spread Duration
102%
-5
-2
-30
EMG
0
-10
HY
IG
% Relative
to Index
10
10
Agy
Mtg. CMBS ABS
Passthroughs
Contribution to Spread Duration by Asset Class
99%
Relative to
Index
17
20
-25
-30
-16
7-9
EMG
-15
-20
Agy
Mtg. CMBS
Passthroughs
ABS
IG
HY
EMG
Market Value and duration contribution statistics reflect values as of the prior business day. Overweight/underweight percentages highlighted in shaded area
represent current date recommendations.
March 17, 2008
Global Relative Value

A Time for Calm:
Market Overshoot/Risk Paranoia Overdone,
but Not Done; Past Recessions Suggest
Long-Term Yields, Spreads, and Equities Only
Halfway to the Cyclical Turning Point
Jack Malvey, CFA
212-526-6686
jmalvey@lehman.com
Joseph Di Censo, CFA, CAIA
212-526-2288
jdicenso@lehman.com
Philip Lee, CFA
212-526-7820
phlee@lehman.com
LEHMAN BOND SHOW WITH

CHIEF U.S. POLITICAL STRATEGIST KIM WALLACE
Washington white horse rescue proposals are galloping out of the Beltway. To help us
make sense of these uncoordinated and ideologically distant plans, Kim Wallace joins Joe
Di Censo on this weeks Bond Show. Please catch our program on www.lehmanlive.com.
In addition, you can now listen to or watch the Bond Show on your iPod by subscribing to
Lehman Brothers podcasts. Easy-to-follow instructions are available under Fixed Income
Webcasts on LehmanLive (Keyword: fiwebcasts).
VOTE IN THE WEEKLY GRV SURVEY QUESTION
What will be most effective in ending this credit recession?
Kishlaya Pathak
212-526-4570
kipathak@lehman.com
1) Use of the Feds balance sheet to buy outright mortgage-backed securities

2) Lowering the fed funds rate to 1% or less
3) The end of financial institution write-offs
4) Major real money investors buying assets
5) A bi-partisan, coordinated, speedy homeowner rescue package
6) Just time
For responses to last weeks survey question and many more, please vote here to see realtime results or consult our capital market daily opinion summary at the end of this
article.
A TIME FOR CALM
Given the recent paucity of good news, lets first savor a few uplifting developments.
U.S. headline and core CPI were both flat in Februarythe first such month for the nonfood and energy component since November 2006. Spring also arrives next week, at least
in the northern hemisphere. And baseball fans await Opening Day in less than two
weeks. Unfortunately, the high spirits stop there.
Like a classic 19th or early 20th century credit crisis, markets seem keen to devise new
anxieties about any and all, real or imaginable, ills. There are legitimate concerns about
this credit recession of 2008. But bereft of anti-agita Zantac treatment, asset price
discovery has given way to anxiety wilding expeditions. Contrary to some recent
National Geographic/Discovery specials, mass extinction or planetary destruction is not
March 17, 2008
likely imminent. Although a few hands may need to be convinced otherwise, a global
Great Depression assuredly is not in the offing either.
Like a vicious loop, anxiety breeds consternation and introduces novel trepidations.
During such episodes of dismay, investors cling to the negatives and assume that their
pessimism will prove justified. Exactly converse to peak bull market mentality, the
despondent bear market mindset knows only anxiety, fear, and negativity.
A time for calm has
demonstrably arrived
Figure 1.
Though often misattributed to Aesop, the sky is falling fable traces back to a Buddhist
Indian folklorequite fitting in our view because a time for calm has demonstrably
arrived. Risk-aversion flagellation of U.S. capital markets reached one of those renowned
convulsive pinnacles, in our opinion.
Three-Stage Credit Sector DamageJune 30, 2007-March 12, 2008

OAS (bp)
U.S.
OAS (bp)
OAS (bp)
%
Jun. 29, 2007 Sep. 18, 2007 % Change Oct. 31, 2007 Dec. 31, 2007 Change
%
Jan. 30, 2008 Mar. 12, 2008 Change
Universal
71
100
40
98
126
28
141
190
Agency
34
45
31
38
43
12
54
81
35
49
MBS
65
72
12
79
87
91
144
59
ABS
74
161
117
141
242
72
250
381
53
CMBS
82
127
56
133
170
28
234
452
93
IG Credit
89
142
59
130
181
40
200
250
25
HY Corp
292
433
49
421
569
35
656
779
19
EM
165
223
35
203
265
30
288
327
14
Universal
20
36
77
33
41
23
49
64
29
Agency
16
28
76
25
30
17
33
44
33
ABS
47
84
78
79
96
22
111
133
21
CMBS
63
104
66
94
110
17
130
143
10
Covered
20
38
90
35
43
23
47
65
36
IG Credit
50
93
87
84
111
33
130
168
29
HY Corp
210
391
87
356
466
31
604
726
20
53
21
24
MBS
60
71
18
73
102
39
99
159
61
ABS
41
50
21
49
52
54
56
Credit
24
35
46
36
48
36
52
69
34
ABX AAA
75
230
206
644
853
32
930
1480
59
CMBX AAA
63
84
33
104
139
33
190
353
86
CDX IG
98
127
30
126
151
20
180
277
54
CDX HY
393
424
482
564
17
660
842
28
ITRAXX Corp
48
78
63
91
125
37
144
249
73
Pan-European
Asia-Pacific
Aggregate
Portfolio Products
Source: Lehman Brothers Fixed-Income Research; Markit
March 17, 2008
Thankfully, market sentiment rarely endures any extreme; clarity and reason quickly
prevail. Despite the frenzy, Mach 2008 bears no resemblance to October 1929. In our view,
markets have arrived in classic overshot territory. Their stay will be brief. Heres why:
Dollar deterioration is
overdone, but not done
Dollar deterioration is overdone, but not done. At a record low to the euro ($1.56) and
Swiss franc (parity) as well as the first double-digit yen handle since September 1995,
the dollar broke significant historical ground in a week. Even with this technical
momentum for further deterioration, there are fundamental limits to this semi-repudiation
of all U.S. assets. Most analysts would concede that a $2.00 euro, $2.50 pound, and 75
reside far in the tails of most forecast distributions. Already oversold, the dollar may
well keep weakening, but consider us cautious about a near-term reversal. The pounds
home economy doesnt appear that dissimilar to the U.S. And the March 31 Japanese
fiscal year-end can amplify directional moves on the dollar-yen cross.
Counterparty risk paranoia is

also overdone, but not done
Counterparty risk paranoia is also overdone, but not done. As the hedge fund tolls mount,
broker-dealer spreads widen, and concerns of systemic financial instability proliferate,
specters of past banking crises understandably haunt risk managers. Continental Illinois
was a quarter century ago (Figure 1) and Bank of New England failed in 1991. And yet the
financial system survived. Then, like now, most predictions will prove to be hyperbole.
With Washington on the move (see this weeks Bond Show), this bout of counterparty risk
will also fade after the books open over the next months first-quarter reporting.
Financial institution anxiety

also is overdone, but not done
Shocked by Bear Stearns, but also cognizant of the history of Fed/private sector rescues
and bank consolidations, financial institution anxiety also is overdone, but not done.
First-quarter financial revelations by the 2/29 brigade (Bear, Goldman, and Lehman
Brothers) followed by the 3/31 cohort will at least bring clarity to any potential writedowns, potentially even signaling an inflection point in future balance sheet impairment
as suggested by S&P.
Yield curve lows are overdone,

but not done
Yield curve lows are overdone, but not done. With an inflation reprieve in February, the
Feds more aggressive course will likely deliver fed funds to 1%--meaning more room
for the front-end to descend. Less cooperative inflation readings in the eurozone (at a 14year high of 3.3% in February) may temporarily stay the ECBs hand, but we maintain
that more easing has to get priced in the front-end of the euro curve. By contrast, longend rates do not fully reflect the reflation risk following this monetary policy cycle.
Expect more steepening.
High-grade spread expansion is

High-grade spread expansion is overdone, but not done. As seen in Figure 2, this thirdstage burst in risk premia already eclipses the first two episodes in August and late 2007
for most sectors. Segments of credit (specifically, agency MBS, CMBS, and ABS) have
all priced in the next Great Depression in 2008. Unequivocally, the magnitude of spread
reset exaggerates the default risk implicit in these high-quality assets.
This is not the case in lower-quality credit. The HY corporate bond markets default
statistics only include the last two recessions, the mildest of the post-World War II era.
The greater concentration of lower-quality HY corporate debt combined with a more
severe downturn spells higher overall default rates than in either 1990-91 or 2001.
According to calculations presented by Marty Fridson at the Fixed-Income Analysts
Society on March 11th, a recession 75% as potent as the median of the past two would
produce a 10% default rate because Caa-C debt make up more of the HY universe
(currently 13%). A 1990-91 style recession would deal a 17% default rate. By that
reasoning, even a low probability of an early 1980s-style contraction suggests that HY
spreads have more room to expand from 793 bp.
Commodity appreciation is
March 17, 2008
Commodity appreciation is overdone, but not done. At $110 for a barrel and $1,000 an
ounce ($1,000), oil and gold typify speculatively-driven commodity peaks. Yet as seen in
10
Figure 2, these primary inputs arent alone. Our 20-member commodity index gained
another 3% in the month to March 14, upping the cumulative 2008 return to 18% and the
12-month appreciation to 49%. Over the past year, wheat (131%) and biodiesels (113%)
more than doubled. Despite the admitted supply constraints and green policy
distortions, such rapid surges smack of speculative momentum.
In contrast, central bank
generosity is neither overdone,
nor done
In contrast, central bank generosity is neither overdone, nor done. European, Australian,
and some Asian central banks may fret over inflation, but monetary authorities cannot
indefinitely overlook growth downside risks. We maintain that rates cuts will become
more geographically diverse than over the past nine months. Our economics team now
expects a 75 bp ease on March 18, though more cannot be ruled out. And along the
ideological continuum of the TAF then TSLF plans, the next Fed effort may include
outright purchases of mortgages, private label included. In our opinion, the requisite
policy course will include greater direct use of the Feds balance sheet.
Similarly, Washingtons white

horse plans are neither
overdone, nor done
Similarly, Washingtons white horse plans are neither overdone, nor done. In concert
with the Feds quasi-surgical approach to intervention, Washington needs to catch up
with acutely targeted plans to forestall the foreclosure/home price depreciation freefall.
As discussed on this weeks Bond Show, our Kim Wallace sees a window of opportunity
for bi-partisanship in the pre-election third quarter.
Figure 2.
Global Index Returns2H07 versus January 1, 2008-March 13, 2008
Index
2H 2007
March 13, 2008
Excess (bp)
Total (%)
Excess (bp)
Total (%)
Universal
-243
5.34
-306
0.60
Aggregate
-176
5.93
-253
1.04
3.85
U.S.
Treasury
7.92
Agency
-21
6.51
-130
2.25
MBS
-115
5.79
-164
1.29
CMBS
-366
5.12
-1,351
-8.71
ABS
-596
0.65
-498
-1.23
Investment-Grade Credit
-466
4.31
-424
-0.15
High-Yield Corporate
-917
-0.97
-873
-4.31
Emerging Markets
-520
4.11
-403
0.19
Index
2H 2007
March 13, 2008
Excess (bp)
Total (%)
Excess (bp)
Pan-European Aggregate
-92
3.17
-108
1.86
Pan-European Credit
-314
1.67
-316
-0.25
Pan-European High-Yield Corporate
-777
-3.81
-1,054
-7.17
Euro-Aggregate
-73
2.81
-94
2.42
Euro-Aggregate Credit
-268
0.93
-260
0.96
Non-U.S.
Total (%)
Asian-Pacific Aggregate
-9
2.44
-7
1.36
Asian-Pacific Credit
-73
1.26
-72
0.54
Source: Lehman Brothers Fixed-Income Research
March 17, 2008
11
And tactical portfolio

defensiveness is not done
or overdone
And tactical portfolio defensiveness is not done or overdone. After the most challenging
year for U.S. active managers since 1983, the first third of 2008 is also shaping up as the
worst launch for equities since 1939 (-16%) and the most egregious 1Q spread sector
underperformance since 1980, when the U.S. Aggregate lagged Treasuries by 326 bp.
The S&P 500 has retreated 12%, inclusive of dividends. Our U.S. Universal Index has
just a 0.60% year-to-date nominal return and a 306 bp underperformance versus
Treasuries. At least the second half of 2007 provided decent absolute bond returns of
5.34% even if with a -243 bp excess return. By most measures, 2008 already surpasses
the pain of endured in the second half of 2007.
So whats the timeline from here? The next couple of weeks, absent of some markedly
potent intervention, breeds significant doubts. The cycle of 2/29 and 3/31 earnings
reports from broker/dealers means that this uncertainty limbo will carry over into midApril. Though May represents the first reprieve from write-down headlines, were not
looking for a substantive halt in risk premium escalation until the summer. Yet even this
window of tranquility opens up to potentially dire third-quarter revelations from the
traditional cyclical industries, by then encumbered after several months of constrained
consumption and tighter credit conditions.
The third-quarter may well present yet a fourth stage to this credit recession, emanating
from traditional corporate downgrades and an uptick in defaults on the one-year
anniversary of the start. When to back up the truck on risky assets? Wed nominate 3Q
2008. Along the way even bear markets can call timeouts: the summer and late
November/December may be the only two for 2008. Yet eventually this staccato pattern
will give way to discounting the recovery of 2009-2010.
Complete perfect timing is a rare joyous event for any asset manager and strategist, but
we maintain that these dislocations will be recalled as preferred entry points for highquality debt assets. Portfolio conservatism is still very much in order. Accordingly, we
recommend further reducing our HY underweight from 5% less than the benchmark to
15% short and reiterate our March 12 decision to increase agency MBS passthrough
holdings from 3% underweight to 5% overweight.
Even the most effective public policy solutions will not immediately regenerate liquidity.
Lets heed this time for calm.
HOW FAR ALONG ARE CAPITAL MARKETS ON THE RECESSION TRACK?
USING PAST ECONOMIC DOWNTURNS, RATES/SPREADS/EQUITIES
ROUGHLY HALFWAY TO THEIR CYCLICAL TURNING POINTS
When constructing a
hypothetical downturn of
various magnitudes,
equity and debt values may just
be near the midpoint of their
ultimate correction in the
2008(-?) recession
As the founder of the NBERs formal business cycle dating committee, Marty Feldsteins
assessment that the U.S. economy entered a recession should stifle any further debate,
but his subsequent qualification that this downturn could be the worst in the U.S. postwar
experience introduces more questions than answers. How deep, protracted, or painful for
capital markets could this recession be? With history as the only, albeit imperfect, guide
we scored each of the past seven recessions according to their duration, impact on macro
economic parameters, and severity in terms of 30-year Treasury yields, Baa-industrial
spreads, and equity prices. When constructing a hypothetical downturn of various
magnitudes, equity and debt values may just be near the midpoint of their ultimate
correction in the 2008(-?) recession.
In addition to quarterly real GDP, NBER devotes particular attention to four monthly real
macro variables when defining an official recession: personal income (less transfers),
payroll employment, industrial production, and wholesale retail and manufacturing sales.
As seen in Figure 3, we calculated the recession trough value for each monthly
March 17, 2008
12
parameter, as well as the percentage change in 30-year Treasury yields, Baa industrial
spreads, and the S&P 500 from the official start of each recession. Note the
correspondence between severe recessions (as determined by employment, IP, income,
sales, and duration) and the correction in long Treasury yields, spreads, and equities.
By all economic and marketbased measures, the last two
recessions were relatively mild
Figure 3.
By all economic and market-based measures, the last two recessions were relatively mild.
Employment contracted less than 2% in the 1990-91 and 2001 recessions, compared with
more than 3% in 1981-1982 and over 2% in 1960-61. Similarly, incomes never fell as
much as in 1973-1975 (-6%) or even 1980 (-3%). The decreases in industrial production
and sales were a fraction of shocks featured in the 1960s/70s/80s. Most obvious, the past
two recessions were the shortest of post-World War II era (1980-1982 was really one long
recession and the omitted 1957 recession was also eight months).
Percent Change from the Beginning of NBER Recession
Empl
Inc
IP
Sales
Duration
(months)
30yr
Baa
1960-61
-2.3%
-0.9%
-6.2%
-5.3%
10
-11%
48%
-2%
1969-70
-1.2%
-0.2%
-5.8%
-4.1%
11
-13%
53%
-21%
1973-75
-1.9%
-5.7%
-13.1%
-12.9%
16
0%
161%
-34%
S&P 500
1980
-1.1%
-2.7%
-6.9%
-6.8%
-7%
131%
-11%
1981-82
-3.1%
-1.1%
-9.6%
-6.2%
16
-22%
99%
-18%
1990-91
-1.4%
-2.6%
-3.9%
-4.1%
-11%
36%
-15%
2001
-1.8%
-1.2%
-4.2%
-3.0%
-13%
9%
-30%
-10%
40%
-13%
4Q 2007Median
-1.8%
-1.2%
-6.2%
-5.3%
10
-11%
53%
-18%
Avg.
-1.8%
-2.1%
-7.1%
-6.1%
11
-11%
77%
-19%
As % of Median
1990-91
82%
205%
63%
77%
80%
100%
68%
80%
2001
100%
100%
68%
56%
80%
117%
17%
163%
50% worse than median
-2.6%
-1.9%
-9.2%
-8.0%
15
-16%
79%
-27%
75% worse
-3.1%
-2.2%
-10.8%
-9.4%
18
-19%
92%
-32%
100% worse
-3.5%
-2.5%
-12.3%
-10.7%
20
-22%
105%
-36%
1973-75
-1.9%
-5.7%
-13.1%
-12.9%
16
0%
161%
-34%
50% worse
59%
51%
48%
75% worse
51%
44%
41%
100% worse
44%
38%
36%
25%
38%
Hypothetical
How far are we along? (% of the trough)
1973-75
Source: NBER, Lehman Brother Fixed-Income Research
March 17, 2008
13
Though the past two recessions

were the most benign for the
real economy, they were still
relatively pronounced for
financial markets
Though the past two recessions were the most benign for the real economy, they were
still relatively pronounced for financial markets. The 11%-13% decrease in 30-year
Treasury yields was the sharpest since 1981-1982 (-22%). And the 30% decrease in the
S&P 500 during the 2001 recession rivalled the 34% collapse during 1973-1975. Yet
credit spreads escaped both 1990-1991 and 2001 rather unscathed (2002 was another
matter) compared with their more than doubling in the mid-1970s and early 1980s.
Industrial bond risk premia

(already 40% wider at 265 bp)
are less than half way to their
ultimate peak
How far to the bottom of this cycle? We hypothesize four recessions of increasing
intensity from the median of the past seven recessions: 50% worse, 75% worse, 100%
worse, and a replay of 1973-75. By scaling the impact on rates, spreads, and equities by
these factors, we hypothesize the corrections in financial assets. The so far undated
current recession likely began in late 2007/early 2008; we assumed 4Q07 for
conservatism. As such, the 10% fall in 30-year Treasury yields to 4.36% is between 44%
of the ultimate decrease (the 100% worse case recession) and 59% of the way (under the
50% intensity recession. A replay of 1973-75 means significant curve steepening such
that rates have to rise. The same exercise for credit spreads demonstrates that industrial
bond risk premia (already 40% wider at 265 bp) are less than half way to their ultimate
peak. Depending on the magnitude of contraction, the 13% slide in equities represents
just one-third to half of historical recession price bottom in the S&P 500.
History is always an incomplete guide, but wed place capital markets only about halfway along the recession price track in early 2008.
RESPONSES TO GLOBAL RELATIVE VALUE SURVEY QUESTION
1) Looking back from March 2010, which asset class exhibited the most distress
during 2008 and hence the greatest rebound bargain?
A. Financial institution equity/debt......................................................................29%
B. U.S. dollar........................................................................................12%
C. CMBS..................................................................................24%
D. Agency MBS passthroughs...............................................................5%
E. Leveraged loans.......................................................................................15%
F. Munis...........................................................................15%
We agree with the consensus on a strategic basis, but favor CMBS, leveraged loans, and
munis for great comeback candidates over the balance of 2008. Lets review this
survey question in late December.
2) Whats the best Washington policy option to enhance systemic liquidity?
A. More Fed eases..................................................................................................7%
B. FHA expansion................................................................................................15%
C. Explicit U.S. govt guarantee of Fannie/Freddie debt.....................................24%
D. Expanded use of Fed balance sheet.................................................................54%
The Fed partially pre-empted this question with the new Term Securities Lending
Facility (TSLF), but this arrangement to accept private-label mortgage collateral for U.S.
Treasuries still doesnt constitute a direct expansion of the Feds balance sheet. If the
evolution of TAF to TSLF provides any guidance of future actions, the Feds next step
could be more akin to the majoritys preferred policy option: expanded use of the SOMA
portfolio to own mortgages outright.
March 17, 2008
14
3) What medium-term effect will the Feds new Term Securities Lending Facility
(TSLF) have for improving liquidity?
A. Terrific...............................................................................................................9%
B. Modest improvement.......................................................................................73%
C. No effect at all...................................................................................................4%
D. Ultimately harmful for normalization..............................................................14%
We agree with the consensus, but a renewed sell-off in the U.S. dollar (to an all-time low
versus the safe-haven Swiss franc), a new peak for oil at $110, and counterparty risk
anxiety suggest that markets are more skeptical. Still this program is having some effect.
While 3-month OIS spreads are back above 80 bp (from 60 bp), 2-year swap spreads
tightened from 112 bp last week to 88 bp and 30-year FNMA CC OAS compressed 28
bp since March 7, to 51 bp (-36%).
4) Which U.S. economic cycle does the current downturn most resemble?
A. 2001...................................................................................................................2%
B. 1990-91............................................................................................................24%
C. 1980-82............................................................................................................10%
D. 1973-75............................................................................................................34%
E. The Great Depression......................................................................................24%
F. There is no recession.........................................................................................5%
As discussed above, this current downturn will likely surpass both 1990-1991 and 2001
in magnitude and duration. Yet were very confident another Great Depression remains a
highly remote outcome, even though some prominent pundits continue to raise this
analogy.
If you havent responded to our surveys, click here to vote and receive real-time responses.
SUMMARY OF LAST WEEKS DAILY GLOBAL RELATIVE VALUES
Staying overweight U.S. munis: Even after early March rally (3.02% total return),
still historically cheap; normalization could deliver another 5.85% price
appreciation. As the best performing asset class in early March (even topping
commodities, 2.32%), U.S. munis are rallying handsomely from all-time wide yields
relative to U.S. Treasuries at the end of February. Our fixed-rate Municipal Bond Index
generated a 3.02% total return in the first seven days of March alone, bringing this asset
class to a flat position over the past three months. Yet munis still present historically
cheap valuations relative to taxable U.S. Treasuries and could deliver another 5.85%
price return if their percent yields revert back to one-year averages. March 11, 2008
From TAF to TSLF: Another acronym for liquidity; Raising U.S. MBS
recommended allocation from 3% underweight to 5% overweight. The new Term
Security Lending Facility (or TSLF) represents the Feds most recent liquidity
countermeasure. As with past borrowing programs, capital markets cheered. Unlike the
Term Auction Facility (or TAF), which the Fed expanded to $100 billion last Friday, or
serial term repos (also announced on March 7), this latest proposal contains provisions
especially targeted to mortgages (bond-for-bond lending that accepts AAA/Aaa private
label MBS collateral) and operates among primary dealers instead of depositary
institutions. After a tactical move to 3% underweight MBS in our U.S. Aggregate
portfolio on February 15, we captured 160 bp of this asset classs 260 bp
March 17, 2008
15
underperformance vs. Treasuries year-to-date to March 10th. The cumulative effect of

Fed easing, new lending programs, and wider spreads will eventually begin to attract
unleveraged investors to this high-quality asset class. March 12, 2008
One measure of liquidity diminution: Global gross debt origination down 14%
year-over-year to $780 billion in February; Not yet the sharpest contraction ever,
but fixed-income primary markets still running at just 75% of pre-July 2007 pace.
Now in month nine of this credit recession, primary debt market liquidity is rapidly
approaching a contraction associated with past downturns. After just $780 billion of
supply in February, new issue volume has fallen 14% year-over-year for the first
decrease in the trailing 12-month supply tally since July 2005. In addition, the past eight
months since last July represent a 24% reduction in issuance vis--vis the pre-crisis
period (Nov. 2006-June 2007). Yet illiquidity still remains fairly concentrated in a few
asset classes, especially non-agency securitized products and lower-quality credit. March
13, 2008
For a further treatment of these topics, consult our Daily Global Relative Value archive
at www.LehmanLive.com.
March 17, 2008
16
Equity Strategy
Can Japan De-Couple?
Ian Scott
44-207-102-2959
iscott@lehman.com
Paul Danis, CFA
44-207-102-2545
pdanis@lehman.com
In the current environment, good news comes at a premium. We are thus a little surprised
that the market has not responded more positively to some of the recent data in Japan, at
least on a relative basis. In no sense can we describe the economic outlook there as
good, but with expectations already low and the speed with which sentiment regarding
the U.S. economy has deteriorated in recent weeks, we think a better relative
performance is justifiable. We remain overweight.
Of course, ones description of performance trends in Japan this year depends crucially
on whether we are talking about common currency or local currency returns. Our
approach in recommending an overweight position is a common currency one, and
Figure 1 indicates that the Japanese market has now stopped underperforming the rest of
the world.
However, given the improved tone to the macro data of late, there is a case for
outperformance rather than this in-line showing. First, sentiment among the small
business community has turned upward in the past two months. The popular Shoko
Chukin Index of sentiment among small and medium-sized businesses has recovered to
47.4 from its plunge during 2007. The recovery in sentiment is also evident in an
improvement in machinery orders, which rose by 4% in January compared with the same
period a year ago (on a three-month moving-average basis).
On the financial side, too, there have been some slightly more encouraging signs from
bank lending statistics. Having begun growing again in 2006, lending growth slowed in
2007. Statistics for February indicate a rise in lending of 0.9% compared with the same
month a year ago. Small comfort, perhaps, but improved loan growth rates have been a
key driver for relative earnings growth among the Japanese banks.
Figure 1.
Japan versus World ex-Japan Relative Performance (Dollar Terms)
Jan 2007 = 100
110
Although the Japanese market

has stopped underperforming
(in dollar terms), we think the
recent data support a more
positive response
105
100
95
90
85
80
75
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Source: Lehman Brothers Research
March 17, 2008
17
Figure 2.
Small/Medium-Sized Business Confidence and Machinery Orders
y/y %
55
Some key macro indicators

have shown signs of
improvement in recent months
40
Core Domestic
Machinery Orders (RS)
30
20
50
10
0
45
-10
40
-20
Small & Medium

Sized Business
Confidence (LS)
-30
-40
35
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
Source: Shoko Chukin Bank, Cabinet Office
Figure 3.
Japanese Bank Lending and Bank Sector Relative Earnings
y/y %
Ratio
3
2
Japanese bank lending is

growing more strongly again
100
Aggregate Bank
Lending Ex
Shinkin Banks
(LS)
90
80
70
-1
60
-2
50
-3
40
-4
-5
30
12-month Forward
Earnings: Japanese Banks
/ Japanese Market (RS)
20
10
-6
-7
1992
0
1994
1996
1998
2000
2002
2004
2006
Source: Lehman Brothers Research, Bank of Japan
Figure 4.
Japanese Consumer Spending
y/y %
The Japanese consumer is

showing signs of life
4.0
Household Living Expenditure
2.0
0.0
-2.0
-4.0
-6.0
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Source: Statistics Bureau of MIC
March 17, 2008
18
Consumer spending has also shown some signs of improvement recently. While
consumer sentiment has declined, wage growth has been accelerating. Accordingly,
while Lehman Brothers Japanese economics team forecasts sluggish GDP growth of
1.6% in 2008, a recession is unlikely, and this compares favorably with just 1% growth
in the U.S.
As mentioned above, none of this adds up to a positive outlook, but given the low
level of expectations, we think it represents at least a relative improvement. Moreover,
analysts earnings revisions have deteriorated at a rapid pace in recent weeks. In the
past, such negative revisions have been followed by a recovery and, with it, a jump in
market performance. The recent rise in business confidence also suggests that revisions
are close to a turn.
So, in the search for areas of the global equity market with the potential to de-couple
from the currently bearish sentiment, we think the Japanese market merits an overweight
position.
Figure 5.
Japanese Wage Growth
y/y %
1.0
Average Monthly Scheduled
Cash Earnings*
0.5
probably as a result of some

better wage growth
0.0
-0.5
-1.0
-1.5
-2.0
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Source: Ministry of Health, Labour and Welfare
Figure 6.
51
Although the strength of the yen

has led to some aggressive
downgrades, the improvement
in sentiment suggests to us that
we may be close to a turn
Japanese Earnings Revisions and

Small/Medium-Sized Business Confidence
Small & Medium

Sized Business
Confidence (LS)
Net Earnings Revisions % (Up Down) / Total
49
2
47
-3
45
43
-8
41
Earnings
Revisions
Balance (RS)
39
37
1991
1993
1995
1997
-13
1999
2001
2003
2005
2007
-18
2009
Source: Shoko Chukin Bank, Lehman Brothers Research
March 17, 2008
19
Global Economics
Liquidity Lesson
Paul Sheard
212-526-0067
psheard@lehman.com
The Fed is not so much injecting liquidity as trying to improve market liquidity.
The actions by the Fed and other G-10 central banks in the past week to address
heightened liquidity pressures in term funding markets (March 7 Fed statement) marked
another milestone in the unfolding credit crunch. But how exactly do such actions by
central banks promote liquidity?
The term liquidity is used, often in the same breath, to refer to three distinct
phenomena. The first is the common but surprisingly subtle notion of central banks
injecting liquidity into the banking system. The second refers to the difficulty that
troubled financial institutions can experience in funding themselves, as when they are
said to face a liquidity crisis. The third relates to the volume, and associated ease,
of transacting in financial markets (without affecting prices), as when liquidity is said
to dry up.
The liquidity in the first case refers to the reserves created on the liability side of the
central banks balance sheet and the asset side of banks balance sheets when the central
bank buys government debt and other assets from banks (open market operations) or
lends funds to banks against collateral provided (discount-window lending or the Feds
new Term Auction Facility [TAF]).
The TAF expansion and the term repurchase transactions announced by the Fed last
Friday add no more net additional reserves to the banking system than had the schemes
not been announced. That is, any reserves supplied this way will need to be offset by
fewer reserves supplied another way. The Term Securities Lending Facility (TSLF)
announced by the Fed this week not does even involve any supply of reserves; rather, it
just involves the exchange of one kind of security (Treasuries) for another (federal
agency debt and residential mortgage-backed securities [MBS]). So the idea that central
banks are injecting liquidity in the first sense is a bit of a red herring.
There can be a link between the provision of liquidity by the central bank and a liquidity
crisis at a bank or in the banking system (the second sense). If a bank experiences a run on
its deposit base, its reserves will be depleted and the central bank will likely act as lender
of last resort by supplying these reserves. But in the current episode, other than in
isolated cases such as Northern Rock, this is not a live issue. Something else is going on.
Recent central bank actions appear to be aimed at improving liquidity in the third sense.
But the capacity of central banks to have much impact here is limited and indirect. Under
the TSLF, the Fed does not buy MBS outright, so the price risk continues to reside in the
market. True, by taking MBS onto its balance sheet as collateral, and to the extent that it
rolls over the operations, the Fed is providing a warehousing function analogous to
another source of buying. By taking assets out of the market, it is also altering the
relative supplies of these assets, making MBS scarcer, for instance. However, given the
relatively small scale of the operations and the fact that they do not directly alter
fundamentals, they are likely to have only second order effects.
As with any central bank action, there can be positive announcement effects. Such action
can have a disproportionately large beneficial effect on market liquidity by serving as a
March 17, 2008
20
circuit breaker and restoring the willingness of counterparties to trade. But the chances of
a central bank pulling off this confidence trick are slim.
None of this is to suggest that central banks should not be trying everything in their
power to re-liquefy financial markets. They should. But given the scale of the problems,
we should not expect too much from any one moveand for that reason, we should
expect many more policy moves before the current problems are resolved.
March 17, 2008
21
U.S. Economics
Street-Fighting Man
Ethan Harris
212-526-5477
eharris@lehman.com
As it seeks a way to unclog capital markets, the Fed is making the best of a tough situation.
The Fed is likely to

combat the risk of a major
recession aggressively
This episode underscores not only how aggressive the Fed wants to be, but how tough it
will be for policymakers to bring about a sustainable market turnaround. For both these
reasons, we expect further Fed action, including aggressive rate cuts. Chairman Ben
Bernanke understands that without aggressive policy, a major recession is likely. Thus, if
one attempt to unclog the markets fails, try another. In a street fight, the more aggressive
fighterthe guy willing to escalate the stakesusually wins.
Capital markets have continued to sell off despite a series of aggressive monetary and
fiscal policy moves. The latest example: on Monday, the Fed announced a new Term
Securities Lending Facility (TSLF)essentially a way for primary dealers to lend
illiquid assets, such as MBS, to the Fed in exchange for liquid Treasury securities. This
sparked a sharp market rally on the day of the announcement, but true to form, the
markets have already given back much of the gains on news of the collapse of the
Carlyle Capital fund, broker counter-party risk, the breaching of the 100 JPY/USD
barrier, and record USD prices for gold and oil.
Outlook at a Glance
%
1Q07
2Q07
3Q07
4Q07
2007
2008 E
2009 E
0.6
3.8
4.9
0.6
-0.5
-1.0
2.0
1.0
2.2
1.0
0.7
Private Consumption
3.7
1.4
2.8
1.9
0.5
0.0
3.5
1.5
2.9
1.4
0.2
Government Expenditure
-0.5
4.1
3.8
2.2
1.4
1.8
1.8
1.5
2.0
2.1
1.2
Non Res Fixed Invest
2.1
11.0
9.4
6.9
1.0
-2.0
-2.7
-3.3
4.8
2.3
-2.5
Real GDP
Residential Fixed Invest
1Q08 E 2Q08 E 3Q08 E 4Q08 E
-16.3
-11.8
-20.5
-25.2
-28.0
-22.0
-10.0
-5.0
-17.0
-21.1
-3.1
Exports
1.1
7.5
19.1
4.8
6.0
6.0
6.5
6.5
8.0
7.5
6.3
Imports
3.9
-2.7
4.3
-1.9
4.0
3.0
3.8
3.5
1.9
2.2
1.9
Domestic Final Sales
1.7
2.1
2.5
1.1
-0.5
-0.7
2.1
0.9
1.9
0.7
0.0
Inventories
-0.6
0.2
0.9
-1.6
0.0
-0.4
-0.3
0.0
-0.3
-0.2
0.2
Net Trade
-0.5
1.3
1.4
0.9
0.0
0.2
0.1
0.2
0.6
0.5
0.5
6.2
Contributions to GDP
Unemployment Rate
4.5
4.5
4.7
4.8
4.9
5.2
5.5
5.8
4.6
5.3
Non-Farm Payrolls, 000
109
105
71
80
-37
-40
-60
-50
91
-47
13
Consumer Prices
2.4
2.6
2.4
4.0
4.2
3.5
3.4
2.4
2.9
3.3
1.8
2.6
2.3
2.1
2.3
2.5
2.6
2.6
2.5
2.3
2.5
2.2
2.4
2.0
1.9
2.1
2.2
2.4
2.4
2.2
2.1
2.3
1.8
-163
-350
-375
Core CPI
Core PCE Deflator
Federal Deficit (Fiscal Year, $ billion)
Current Account Deficit (% GDP)
-5.4
-5.0
-4.3
Fed Funds
5.25
5.25
4.75
4.25
2.25
1.25
1.25
1.25
4.25
1.25
1.00
3-Month USD LIBOR
5.35
5.36
5.23
4.70
2.75
1.75
1.65
1.50
4.70
1.50
1.20
TSY 2-Year Note
4.58
4.86
3.98
3.05
1.45
1.45
1.55
1.55
3.05
1.55
1.65
TSY 5-Year Note
4.54
4.92
4.24
3.44
2.35
2.35
2.45
2.45
3.44
2.45
2.55
TSY 10-Year Note
4.65
5.02
4.59
4.02
3.55
3.55
3.65
3.65
4.02
3.65
3.65
Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates. Unemployment rate is a percentage of the labor force. Inflation
measures and CY GDP are y-o-y percent changes. Interest rate forecasts are end of period. Payrolls are monthly average changes.Table last revised March 14.
All forecasts are modal forecasts (i.e., the single most likely outcome).
March 17, 2008
22
We look for the Fed to cut rates

to 1% by early 2009
With this in mind, we have, yet again, cut our funds rate forecast. We now expect the Fed
to cut by 75 bp on March 18, 50 bp in April, 50 bp in June, and by a final 25 bp in early
2009, bringing the funds rate back down to 1%. Who says history does not repeat itself?
Bernanke Bashing
The Bernanke Fed has been

under intense criticism
Ben Bernanke must be feeling a bit of dj vu these days. In a speech on January 7, 2005,
he recalled his days on a local school board: Six grueling years during which my fellow
board members and I were trashed alternately by angry parents and angry taxpayers. In
the past two years, a similar trashing is occurring, this time by people who think the
Bernanke Fed has eased too much and those who think it has eased too little.
One of which is that aggressive

Fed easing is rewarding
risk takers
One view is that aggressive Fed easing is rewarding risk takers, laying the groundwork for
another asset bubble and a serious bout of inflation. Alan Meltzer, an economic historian of
the Federal Reserve System, writes: Is the Federal Reserve an independent monetary
authority or a handmaiden beholden to political and market players? Has it reverted to its
mistaken behavior in the 1970s? Recent actions and public commitmentsleave little
doubt on both counts. 1 And the Wall Street Journal notes that the dollar and commodity
markets are giving a clear vote of no confidence in the Feds anti-inflation resolve. 2
The bottom line seems clear: the Fed has made a major mistake by ignoring
inflation/growth risks and rewarding risk takers/allowing the markets to collapse and
easing too little/too much. Why cant they get it right?
A No-Win Situation
It is important to recognize that

the Fed is in a no-win situation
Figure 1.
Before we draw and quarter Bernanke and his buddies, it is important to recognize that
the Fed is in a no-win situation: it cannot ease and tighten at the same time. The real
question is, has the Fed found the right balance between trying to revive growth and
trying to resist inflation? With persistent problems in the housing and credit markets, we
think that Fed easing is unlikely to revive growth enough to create a serious inflation
problem. Indeed, in 2008 and 2009, we look for cumulative growth of just 1.7%, marking
the fourth-weakest two-year growth rate of the post-war period (Figure 1).
Annual GDP Growth
Figure 2.
% y-o-y
10
Forecasts
Consensus Forecasts
Forecast
Date
GDP
CPI
% Q4/Q4
% Q4/Q4
2.8
2.3
5.00
Sep-07
2.5
2.3
4.75
Dec-07
2.2
2.3
4.00
Jun-07
6
4
2
Fed Funds
GDP and CPI are growth over next four quarters, funds rate is four quarters
ahead
0
-2
1949 1956 1963 1970 1977 1984 1991 1998 2005
Source: Commerce Dept, Lehman Brothers
Source: Bloomberg
1
2
March 17, 2008
That 70s show, Wall Street Journal, February 28, 2008.

The Bernanke Reflation, Wall Street Journal, February 29, 2008.
23
If anything, we think the Fed is behind the curve and should have eased earlier. However,
the Feds actions should not be judged relative to the views of the most pessimistic
forecasters, but relative to conventional forecasts. Had the Fed eased back in 2005 or
2006, when perma-bears first warned of an impending collapse, it would likely have
stoked an even bigger bubble in the housing and credit markets and even more inflation.
The Fed has moved faster
than the vast majority of
economists had expected
The Fed has moved faster than the vast majority of economists had expected. In the June
2007 Bloomberg survey, just before the crisis escalated, economists expected solid
growth and just one rate cut in the next four quarters (Figure 2). Even the worst
pessimistan economist at a home-building companyexpected 0.4% GDP growth and
the Fed cutting to 3.25%. Three months later, with the capital markets crisis heating up,
most economists expected a replay of the 1998 financial crisis, when three 25 bp Fed
eases restored markets and the economy continued to grow. Even in December 2007, the
consensus was expecting 2.2% GDP growth and a 3.5% funds rate a year ahead. The
most pessimistic forecast assumed a small -0.5% per quarter recession and expected the
funds rate to fall to 3% in the year ahead. In fact, the Fed cut to 3% just a month later.
The Fed did no worse than most

of the economics profession in
forecasting the economy
The obvious lesson from this review of history is that the Fed did no worse than most of
the economics profession in anticipating the depth and economic impact of the financial
crisis. We believe there were two reasons for the poor forecasts. First, as the first test of
the modern financial market architecture, historical experience offered no guidance as to
the depth or even the nature of the crisis. Second, economic models have a hard time
quantifying credit crunches. Even today, the consensus believes that U.S. GDP growth
will be weak or slightly negative for only a few quarters.
March 17, 2008
24
The Week Ahead

Drew Matus
212-526-9878
dmatus@lehman.com
Michelle Meyer
212-526-7977
mimeyer@lehman.com
Zach Pandl
212-526-8010
zapandl@lehman.com
We look for the Fed to cut rates 75 bp, to 2.25%, this week while stressing downside risks
to growth stemming from housing and financial markets. We expect the data to show an
economy in a mild recession with a decline in industrial production and housing starts.
Current Account Balance (Monday)
On a nominal basis, the current account likely deteriorated slightly in 4Q, as a pickup in
import prices should offset an improvement in real trade flows. Specifically, we look for
a widening of the current account deficit to -$181.3 billion, or 5.2% of GDP. Despite the
setback in the current quarter, however, fundamentally the current account looks set to
improve: the dollar continues to depreciate, and U.S. growth looks to be slipping into
recession, while foreign demand remains robust. The current account deficit has already
narrowed from a peak of 6.8% of GDP in late 2005, and we expect it to fall to just 4.0%
of GDP by the end of next year.
Empire State Survey (Monday)
We look for a minor

improvement in the
Empire State survey
We look for a minor improvement in the Empire State survey after a nearly 21-point
decline last month. For February, we expect a reading of -9.0, versus the -11.7 reported
in January. Manufacturing activity across the country is likely to be weak in February,
with the exception of export-driven manufactured goods producers.
Net International Capital Flows (Monday)
Overall net capital inflows are

expected to rise to $75 billion
Overall net capital inflows are expected to rise to $75 billion in January, a modest
acceleration from the growth in December. We expect continued growth in money market
asset accumulation from foreign investors after a period of dollar repatriation late last year.
Industrial Production (Monday)
We expect a weak industrial

production report
Figure 1.
We look for industrial production to fall 0.3% in February after rising for the past three
months. This decline should drag the capacity utilization rate down to 81.4%.
Manufacturing production, which accounts for roughly 80% of total output, should also
Current Account Balance
Figure 2.
$bn
0
%
0.0
-1.0
-50
-2.0
-100
-150
-4.0
0.0
-7.0
-250
Mar-95
-8.0
Mar-98
Mar-01
Balance, LHS
Mar-04
Mar-07
% GDP, RHS
Source: Commerce Department, Lehman Brothers Global Economics
March 17, 2008
Forecast
0.8
0.4
-6.0
-200
% m-o-m
1.2
-3.0
-5.0
Industrial Production
-0.4
-0.8
Total Manufacturing
-1.2
Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08
Source: Federal Reserve, Lehman Brothers Global Economics
25
fall 0.3%. Survey data have been decidedly weak, with the national ISM pointing to a
contraction and some regional surveys, such as the Philadelphia Fed and Chicago
NAPM, in recession territory. In addition, the manufacturing sector shed 52,000 jobs in
February, and aggregate hours fell 0.5%, suggesting a decline in output. Elsewhere, we
look for an increase in mining output to be offset by a decline in utility production.
NAHB Housing Index (Monday)
Homebuilders are likely to
remain depressed
The NAHB housing index, which measures homebuilder sentiment, has edged higher from
a record low of 18 in December to a still-depressed 20 in February. We look for the index
to hold steady at 20 in March as homebuilders continue to struggle with weak demand and
high cancellations. The deterioration in financial markets has exacerbated the problems in
the housing market by tightening credit and pushing up borrowing costs. Even the agency
market has started to show stress, as rates on conforming (Fannie Mae and Freddie Mac
guaranteed) mortgages have jumped over the past few weeks. In addition, the economic
outlook has continued to worsen, with a decline in payrolls and consumer confidence.
Attention should be on the buyer traffic index, which inched higher in February. A
sustained increase in this index is suggestive of future sales and hopeful for builders.
However, given the huge inventory overhang of homes on the market for sale, we believe
builders will not feel comfortable increasing construction until next year.
PPI (Tuesday)
We look for the February Producer Price Index (PPI) to have risen by 0.5%, following a 1.0%
increase in January. The core PPI is likely to rise by 0.2%, or 2.1% year-over-year. As the PPI
is released after the CPI this month, we expect it to garner little market attention.
Energy and food prices should

continue to boost the
headline PPI index
Energy and food prices should continue to boost headline PPI, as they have in most
recent months. We look for the energy component to rise by 1.4%, close to last months
rate of increase. The food component is expected to cool slightly, rising just 0.5%. Foodrelated commodity prices have turned lower in March, which should lead to lower
finished food prices in time.
We look for core PPI

to rise 0.2%
The core PPI, excluding food and energy, is expected to increase 0.2%. The core PPI has
recently surprised on the upside, with no special factors behind the acceleration. We judge
that the pickup in price pressure reflects pass-through from surging commodity prices. With
Figure 3.
Core PPI and CPI
Figure 4.
months
% y-o-y
6
m, saar
2.0
11
10
9
1.5
1.0
0
-1
Jan-85
Housing Starts and New Home Supply
Jan-89
Jan-93 Jan-97 Jan-01

Core PPI
Core CPI
Source: Bureau of Labor Statistics
March 17, 2008
Jan-05
3
Jan-03
Jan-04
Jan-05
Jan-06
New Home Supply, LHS
Jan-07
0.5
Jan-08
Single Family Starts, RHS
Source: Census Bureau, Lehman Brothers
26
both futures prices and Lehman Brothers official commodity forecasts suggesting that these
price pressures should begin to subside, core PPI should decelerate in a lagged fashion.
Housing Starts (Tuesday)
We look for housing starts to fall just over 4%, to 970,000, in February, as both single- and
multi-family starts edge lower. Multi-family starts have been quite volatile of late, causing
swings in the headline number. The attention should be on single-family starts, which have
contributed to the bulk of the decline in construction. Single-family starts have already
fallen 60% from the January 2006 peak and are likely to continue to decline given the glut
of inventory in the new home market (Figure 4). The supply of homes on the market
reached a new cyclical high in January of 9.9 months, as home sales continued to fall
sharply while inventory only slipped. Builders should slash construction as a result.
FOMC Meeting (Tuesday)
We look for the FOMC
to cut rates 75 bp, to 2.25%
We look for the FOMC to match market expectations and cut the Federal funds rate by
75 bp, to 2.25%. Continued aggressive rate cuts are consistent with the Feds attempts to
re-open the credit channel through the expansion of the TAF program, the recently
announced term repurchase agreement program, and the Term Securities Lending
Facility. The new programs are designed to restore the effectiveness of the Feds primary
policy toolthe Federal funds ratein stimulating the economy. We expect the Fed to
continue to note the obvious downside risks to growth in the economy while also
continuing to pay lip service to inflation concernseven though these concerns are far
removed from the Feds immediate worries.
Initial Jobless Claims (Thursday)
We look for claims to hold above 350,000 and for the four-week average to remain
between 350,000 and 360,000 as labor market weakness continues. This reading should
translate into a 25,000 decline in payroll employment for March.
Philadelphia Fed Survey (Thursday)
Philly Fed survey expected to

show modest improvement but
to stay in recession territory
Like the Empire State survey, we look for the Philly Fed survey to post a modest
improvement to -19.0 in March from -24.0 in February. After plunging sharply in
January, this index has remained close to -20.0, and we see no reason to expect a
significant improvement. We will pay particular attention to the CapEx outlook series: a
sharp deceleration last month put the current quarterly average for this series nearly eight
points below the average seen in 4Q. We view this series as helpful in predicting
business investment on a national scale. Last month, the series printed at 1.7 after posting
a respectable 19.0 reading the previous month. A further decline in March would suggest
that businesses dramatically reduced CapEx spending during the quarter.
Leading Indicators (Thursday)
The index of leading economic

indicators is expected
to decline 0.3%
The index of leading economic indicators is expected to decline 0.3% in February,

marking its fifth consecutive monthly decline. As the economy may have already slipped
into recession, the leading index should begin to stabilize in the months ahead. Indeed,
following the decline in payroll employment in February, we believe the first significant
decline in the coincident indexwhich tracks current economic activitywill be
reported this month.
Good Friday Holiday
U.S. markets are closed for the Good Friday holiday.
March 17, 2008
27
European Economics
Re-coupling with Decoupling
Michael Hume
44-207-102-4191
michael.hume@lehman.com
Genuine decoupling of the European economy from that of the United States remains a
remote possibility. We are now alert to the risks of a sudden and sharp drop in growth.
Even as fears about the outlook for the U.S. economy intensify, a batch of unexpectedly
healthy European data has resurrected talk of possible decoupling. Is it really possible
that just as the U.S. enters recession, Europe can provide some comfort to the rest of the
world by standing on its own two feet?
Materializing Risks
Some optimism about

decoupling has returned
We examined in some detail the issue of decoupling in a report last July. 3 The analysis it
contained suggested that the main risk to the decoupling thesis was a global inflation
shock that constrained the ability of central banks to provide offsetting policy stimulus. A
second risk was a financial shock that was propagated from the U.S. to elsewhere in the
world. We concluded that a U.S. recession would have very different implications for the
rest of the world than a U.S. slowdown would.
but the main transmission

risks have materialized
Nearly nine months on, both of these major risks have materialized, and the U.S. economy
seems to have moved from slowdown to outright recession. In short, even as the European
data may seem to be casting doubt on a synchronized global slowdown, from an analytical
perspective, decoupling in the current environment appears to be about as unlikely a
prospect as it gets. So was the analysis contained within that report wrong-headed? Or are
the data a red herring on the path to much lower growth in Europe? We side with the view
that recent figures are a red herring. In fact, we are becoming increasingly concerned that a
sudden and sharp drop in European growth could be around the corner.
Global Transmission
U.S. rate cuts could be

bad news for Europe
The concern about a global inflation shock was certainly not misplaced. The logic that lay
behind that was that a global inflation shock would constrain the ability of central banks to
offset an autonomous weakening of demand by lowering interest rates. While the Federal
Reserve has acted aggressively even as inflation pressures have risen, two unexpected
developments have outweighed this piece of good news as far as Europe is concerned.
First, in the currency markets, the Feds emphasis on core inflation within a risk
management framework has jarred with the ECBs emphasis on headline inflation within
a policy framework based on a baseline scenario. It has driven the dollar down sharply
against the euro and means that more of the U.S. shock is being transmitted to Europe via
the exchange rate. Second, the pernicious nature of the financial shock means that there
are now serious doubts as to whether lower U.S. interest rates will have their usual
demand-boosting effect. That would be the worst of both worlds for Europe: a U.S.
economy that does not respond to monetary easing combined with a U.S. dollar that does.
given that the ECB is

unwilling to help
In this context, to take the latest domestic data as a sign of decoupling places more weight
on them than they can bear. For example, the positive surprises that have emerged
continue to be loaded toward the manufacturing sector. To summarize, the manufacturing
PMI has held up better than its services equivalent, and industrial production at the
3 1.
Hume, M., Global Decoupling: Does the rest of the world still catch a cold when the U.S. sneezes?, Lehman
Brothers Global Economics, July 6, 2007.
March 17, 2008
28
Figure 1.
Euro-Area PMIs
Figure 2.
index, normalised, sa
Euro-Area Industrial Production
% m-o-m, sa
1.6
1.5
0.8
1.0
0.0
0.5
-0.8
0.0
-1.6
-0.5
-2.4
Jan-03
Jan-04
Jan-05
Manufacturing
Jan-06
Jan-07
Jan-08
-1.0
Services
Sources: Reuters, Datastream, and Lehman Brothers Global Economics
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Sources: Eurostat, Lehman Brothers Global Economics
beginning of 2008 jumped unexpectedly (Figures 1 and 2). But for decoupling to take
place in an environment of a U.S. recession, a switch away from export-led growth in
manufacturing to consumer-led growth in services would be needed. In our view, it is
unrealistic to expect the manufacturing sector to live with a euro-dollar exchange rate of
over $1.55, a recession in the U.S. economy, and the prospect of weaker U.K. economy,
too. Our expectation is that this combination of influences will lead to clear signs of
weakness in exports and manufacturing within the next three to six months.
Hopes Pinned on Germany
Germany is the euro areas
best hope
The great hope is that the German consumer is now ready to come out of his shell and
start spending again, propelled by strengthening wage growth, lower unemployment, and
the fading of the effects of both the VAT hike and the new rules on depreciation for the
self-employed. Optimists argue that the German economy is not at the forefront of this
financial crisis. Although German banks were exposed to subprime losses, the damage has
not been extensive, and credit growth has remained strong. Furthermore, turning back to
the latest industrial production figures, it has been argued that Germanys competitiveness
has improved enough to withstand recent exchange rate shifts. Furthermore, exports to the
oil exporters and the Asian economies now matter more than those to the U.S.
but we are skeptical that the

consumer will recover
There is some truth in all of these arguments, and we expect Germany to be among the
least affected of all the European economies by the current financial crisis. But as usual,
what matters is the magnitude of these effects and what the net impact of all of the various
influences stands to be. Take the argument that nominal wages are rising faster, for
example. This is true and should support consumption. But this stands to be undone by
rising consumer prices. In real terms, we expect German wages barely to rise this year.
That is better than the declines witnessed in more than half of the past five years. But it
can hardly be expected to drive much of a consumer recovery.
March 17, 2008
29
All Fears Elsewhere

We still see a slight
slowdown in 1Q
As for the generally positive start to 1Q in the euro area as a whole, the data are
nonetheless consistent with lower growth, in our view. It is too early to form much of a
view based on hard data, which have been the biggest source of positive surprises. The
preliminary estimates tend to be revised too much, and the possibility of sharp payback in
the February releases means that it is prudent to suspend judgement. Survey data, which
are less volatile, less prone to revision, and timelier, point to another soft quarter.
and a high risk of a slump

in some economies
But it is the possibility of a sudden collapse in activity growth that now preoccupies us. It
is striking that, in the U.S. case, growth seems set to fall so precipitously. In the first
three quarters of last year, U.S. growth averaged more than 3% quarter-over-quarter
(saar). For the subsequent three quarters, we expect the average to be negative. Euro-area
growth, like the U.S. before it, has shown only signs of slowing up until now. But we
will be looking closely at the economys weak linksin particular, Spain, but also
France and Italyfor signs that the slowdown may turn into a slump. If any such signs
emerge, we stand ready to take the knife to our forecasts again.
March 17, 2008
30
Japan Economics
Resilience
The risk that Japan will slide into recession is growing, yet there is still a chance that
recession can be avoided.
Kenichi Kawasaki
8-136-440-1420
kekawasa@lehman.com
Given the potential for the U.S. subprime mortgage crisis to dampen external demand for
Japanese output, the key to avoiding a recession lies in a recovery in domestic demand to
offset any fall in exports. As the U.S. economy slips into recession and worries surface
about the strength of the yen in 1H, a close watch will need to be kept on external and
domestic demand trends. That said, we believe it is too early to say with any certainty
that the Japanese economy will slip into recession. This week, we have nudged down our
growth numbers, but our main scenario remains that the economy will continue to grow,
albeit at a very moderate clip, and that it will be able to stave off a recession (Figure 1).
A Firm Economy
There was only a minor

revision to 4Q07 GDP
Real GDP in 4Q07 rose 3.5% quarter-over-quarter (saar) in the second estimate, only slightly
lower than the 3.7% in the first estimate. The basic statistics and methods used in the first and
second estimates of Japanese GDP statistics differ somewhat. Business investment was
expected to be revised sharply downward as a result of the MOFs corporate survey, used in
the second estimate, but it was only a relatively small amount lower. Moreover, the effect of
the revision was largely offset by the upward revisions in public demand and net trade.
Although the risk of

recession is growing
Real GDP grew more than 2%considered the potential growth ratedespite a decline
in residential investment. Although the risk of recession is rising, Japans economic
situation has not weakened to the point at which it is experiencing negative growth.
consumer sentiment shows

signs of bottoming
First, although consumer sentiment is deteriorating, private consumption is firm. Real

private consumption increased 0.2% quarter-over-quarter in 4Q07. Although the
consumer confidence index, announced this week, continued to worsen in February, the
assessment of both current and future economic conditions improved (Figure 2).
Figure 1. FY Economic Outlook: Lehman versus Official

Lehm an
% y-o-y
BOJ
Governm ent
FY07
FY08
FY07
FY08
FY07
FY08
Real GDP
1.6
1.7
1.8
2.1
1.3
2.0
Nominal
GDP
0.7
1.4
0.8
2.1
GDP
deflator
-0.9
-0.3
-0.5
0.1
Core CPI*
0.3
Figure 2. Consumer Sentiment and Consumption

Index
60
Economy Watcher Survey (LHS)

Consumer Sentiment (LHS)
Index, sa
110
55
50
105
45
40
100
35
0.5
0.0
0.4
0.2
0.3
*Lehman and the BOJ reports core CPI inf lation while the gov ernment
reports CPI inf lation (not excluding f ood and energy ).
Source: Bank of Japan, Cabinet Office, and Lehman Brothers Global

Economics
March 17, 2008
30
25
2002
Real household Consumption (RHS)

95
2003
2004
2005
2006
2007
2008
Source: Cabinet Office, Ministry of Internal Affairs and Communications, and

Lehman Brothers Global Economics
31
Scheduled earnings
are improving
Second, while worker compensation remains soft, increasing just 0.2% year-over-year in
4Q07, scheduled earnings rose 0.6% year-over-year in January, for the third consecutive
month. Total wage growth was soft, but the improvement in scheduled earnings, considered
permanent income, was a positive factor (Figure 3).
Housing starts are recovering
Third, residential investment fell a marked 9.1% quarter-over-quarter, lowering real GDP
by 0.3pp, although the year-on-year rate of decline in housing starts recovered to just
5.7% in January (Figure 4). It will take longer for residential investment, measured on a
construction progress basis, to recover in the GDP statistics. While weak demand for
residential investment is a worry, we believe it is set to start to record quarter-on-quarter
growth in 1Q08, although it may decline in terms of year-on-year changes.
Global trade is firm
Fourth, exports were up 3.1% quarter-over-quarter in 4Q07 and contributed 0.5pp to

growth in real GDP. Exports rose 10.3% year-over-year in January, with a fall in exports
to the U.S. more than offset by stronger shipments to the EU and Asia. We have slashed
our U.S. economic growth rate since publishing our annual outlook in December, but we
have not made similar changes to worldwide imports, partly because of upward revisions
to imports in China and Australia. The Japanese export market is not contracting in step
with the U.S. economy.
A decline in real GDP will

likely be avoided
Industrial production is in a temporary lull, and the risk of Japans sliding into recession
is growingbut this does not mean that real GDP will necessarily fall.
Political Stalemate
A battle has broken out over

who should run the BOJ
Figure 3.
The battle between the ruling and opposition parties over who will get the top jobs at the
Bank of Japan (BOJ) continues, even as March 19the last day of the current governors
termfast approaches. The Diet agreed on the appointment of Masaaki Shirakawa (a
former BOJ executive director) as a deputy, but disagreed with the choices of Deputy
Governor (and former vice finance minister) Toshiro Muto as governor and Tokyo
University Professor Takatoshi Ito as the other deputy. With this political stalemate,
there is a real risk that the governors seat may be left empty.
Total Cash Earnings and Scheduled Earnings
Total cash earnings
2.0
Housing Starts and Residential Investment
mn units, annualised, sa
Private residential investment (rhs)
% y-o-y
3.0
Figure 4.
JPY tr
20
1.4
Scheduled eanings
1.0
1.3
18
1.2
0.0
-1.0
1.1
16
-2.0
1.0
14
-3.0
0.9
-4.0
-6.0
2002
Housing starts (lhs)
0.8
-5.0
2003
2004
2005
2006
2007
2008
Source: Ministry of Health, Labour and Welfare and Lehman Brothers Global
Economics
March 17, 2008
0.7
2002
2003
2004
2005
2006
2007
12
10
2008
Source: Cabinet Office, Ministry of Land, Infrastructure, Transport and Tourism,

and Lehman Brothers Global Economics
32
Ironically, a candidate with

refreshingly sensible views
has been blocked
March 17, 2008
With the economic situation on a tightrope, the BOJ must act as a bulwark. Over the
medium to long term, there will be a need to look at improving the system for developing
monetary policy. We would like to see someone like Professor Ito, who is prepared to put
forward plans for improving the system, appointed to the governors team. For instance,
at the Diet hearings held to canvass the opinions of the governments candidates,
Professor Ito is reported to have said, sensibly in our view: Many countries have
adopted inflation targeting policies; and on the lower limit of price stability, No
developed country has an inflation rate of 0%. We firmly believe that the BOJ
leadership should be appointed based on their qualifications and ability to do the job
not on political imperatives such as their previous affiliations.
33
Asia Ex-Japan Economics

Australia: Mind the Gap
Tight policies aimed at closing the output gap could work too effectively, in our view.
Stephen Roberts
6-128-259-4846
stephen.roberts@lehman.com
We forecast Australian economic growth to slow through 2008 and 2009 as tight economic
policies aimed at damping excessive growth in domestic spending are reinforced by three
other factors: the development of quantitative lending restrictions by banks and other
lenders as they respond to protracted difficulties in credit markets; the effect of the sharp
decline in the price of financial assets on household wealth, notably on the value of $A1.1
trillion of superannuation assets; and a potential weakening in Australias terms of trade.
We see the last coming into play in late 2008, or in 2009, when commodity prices succumb
to the gravitational pull of weaker global economic growth.
Rob Subbaraman
8-522-252-6249
rsuba@lehman.com
Wide Output Gap Needs Tough Policy Action

Strong domestic spending has
widened the output gap
The latest national accounts data for 4Q07 showed year-on-year growth in real final
domestic spending running much stronger than that of total real GDP (Figure 1), adding to
upward inflation pressure. The new Rudd administration and the Reserve Bank of Australia
(RBA) view demonstrably tight macroeconomic policy settings as an imperative in order to
close the output gap and cap inflation. In terms of fiscal policy, unlike its predecessor,
which used the terms of trade windfall to cut taxes, the Rudd administration intends to
cut spending and to reprioritize expenditure away from boosting demand and toward
improving infrastructure and the supply side of the economy.
A tough budget promises help

in fighting inflation
However, we see the government cutting spending in the May budget by only enough to
counter the effect of softer growth on the budget parameters. The government should still
generate a 2008-2009 budget surplus of 1.5% of GDP, similar to that in 2007-2008. The
shift of budget spending toward boosting supply rather than demand is also likely to be
small, in our view, because of a double dose of mandated personal tax cuts commencing
July 1. This includes the second round of tax cuts from the last Howard budget and the
Rudd administrations first round of tax cuts promised in the election.
Figure 1.
Annual Real Growth in GDP and Demand
Figure 2.
Mortgage Interest Margin over the Cash Rate
Basis points
% y-o-y
Real GDP
210
Real final domestic demand
200
190
180
170
160
3
2
Dec-03
150
140
Aug-04
Apr-05
Dec-05
Source: Australian Bureau of Statistics
March 17, 2008
Aug-06
Apr-07
Dec-07
Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08

Source: Reserve Bank of Australia and Lehman Brothers
34
but that task rests

mainly with the RBA
We see the inflation-fighting role of a tighter budget position as limited, as it will have an
effect too late in 2008 to help deal with the immediate problem. Instead, the burden of
tightening policy rests largely with the RBA, as evidenced by its willingness to hike rates
in four 25 bp steps to 7.25% in March, despite the deteriorating global economic
backdrop. The effect of the cash rate hikes on housing and personal loan interest rates
has been magnified by lenders passing on part of the lift in their borrowing costs from
widening credit spreads (Figure 2). Since the onset of the credit crisis in July 2007, the
interest rate on a standard variable rate bank home loan has risen around 125 bp, to 9.3%,
a big enough increase, in our view, to drive down the growth in real final domestic
demand from 5.7% year-over-year in 4Q07 to less than 2.5% in 4Q08.
There are three

more headwinds
We see three more reasons the weakening in domestic spending could be more
pronounced than many forecast.
There are signs of

credit rationing
First, tight monetary conditionsin the form of high interest rates and a strong
Australian dollarare being reinforced by the first signs of quantitative credit rationing
imposed by lenders as they struggle to cope with the continuing dislocation in their
funding arrangements. Credit rationing to businesses and households, combined with
high interest rates, heightens the risk of a sharper-than-expected reduction in credit
growth and domestic spending.
Asset price falls may lead to

negative wealth effects
Second, declines in the prices of financial assets in Australia have ranked among the
biggest internationally. The ASX 200 has fallen as much as 25% from its peak in
November and by 19% since the end of 2007. Listed property trusts (REITs), which have
been particularly popular investments in household investment portfolios, are down 38%
from their October peak and 26% from the end of 2007. The effect of these falls is likely
to be pronounced on the value of Australias massive superannuation (pension) savings
(A$1.1 trillion in 4Q07), of which A$300 billion was in self-managed arrangements with
a high weighting in equities. We see this negative wealth effect curtailing spending,
particularly by pre-retirees and those in their early retirement years; people in this age
cohort, because of their limited net borrowings, are generally less affected by higher
interest rates than younger people, who typically have more debt.
The improvement in the terms

of trade is set to reverse
The third constraint on growth relates to Australias strong terms of trade, the primary
force driving strong growth in national income and spending over recent years (Figure
3). Near term, the terms of trade are likely to continue to improve, partly because of the
long lags involved in negotiating annual contract prices for coal and iron ore, as well as
Figure 3.
Terms of Trade
Figure 4.
Index, 2005-06 = 100

110
Index
100
120
90
110
80
100
70
90
60
Jun-00
Sep-01
130
Dec-02
Mar-04
Source: Australian Bureau of Statistics
March 17, 2008
Consumer Sentiment
Jun-05
Sep-06
Dec-07
80
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Source: Westpac-Melbourne Institute
35
strong buying of commodities by investment funds, causing prices to spike higher. But
we expect the terms of trade to weaken later in 2008, once global commodity markets
reflect the influence of softer global economic growth.
The RBA is set for a long pause,
and then to cut in 2009
March 17, 2008
In our view, the gap between the growth rates in domestic spending and GDP was at its
widest point in 4Q07 and is likely to narrow sharply in 2008. Most economic readings
for early 2008 are pointing to less robust domestic spending. Consumer sentiment, for
example, has weakened sharply (Figure 4). Retail sales were flat in January, and home
building approvals stepped down in December and January. We expect the RBA to take a
lengthy pause as it determines the effect of its substantial tightening of monetary
conditions since mid-2007. If our forecasts are on the mark, the RBA is likely to take the
view over coming months that the output gap is closing rapidly, giving it more
confidence that inflation will moderate in 2009. We expect the RBA to be giving the first
hint of rate cuts by the end of 2008 and to cut rates by 75 bp in 2009.
36
Political Analysis
Building on an Infrastructure Finance Strategy
Kim N. Wallace
202-452-4785
kwallace@lehman.com
Chuck Marr
202-452-4747
cmarr@lehman.com
Tony Clapsis
202-452-4765
aclapsis@lehman.com
Members of both parties

decried the lack of U.S.
infrastructure investment
Washington is transitioning into another period in which big ideas will be required to
address large, complex challenges. Two are follow-ons to consequences of policy
commitments begun by President Bush (low tax and expansive geostrategic initiatives);
one has been building for many decades without much specific Washington attention
(demographys effect on fiscal balances), and for two, much has been said but little has
been accomplished (greenhouse gas emissions and the geopolitical significance of wealth
spikes in developing countries).
Federal policymakers of late have joined state and local public managers in focusing on
the economic growth and longer-run benefits of public works investment. This trend in
Washington and the states lags international developments. Global infrastructure
investment is being spurred by recently abundant self-financing available in developing
regions and two decades of meager spending in the U.S.
Public and private decision makers have long focused on infrastructure as an area in
which investment makes sense for those looking to put capital to work and users whose
quality of life and economic output are constrained by inadequate public works.
Bicameral, bipartisan support is growing in Washington for a federal financing bank
designed to encourage private and public investment and management of public
infrastructure. House Speaker Pelosi (D-CA) on Wednesday added her support to
legislation introduced by Senate Banking Committee Chairman Dodd (D-CT) that would
create a bank to finance infrastructure projects of national priority. At a March 11
hearing on the bill (S. 1926), members of both parties decried the lack of U.S.
infrastructure investment and, along with all witnesses, agreed that public and private
financing (including foreign sources) would be needed to meet mounting demand for
affordable housing, surface, air, and waterway transportation projects. The
accompanying graph shows the drop off in federal infrastructure outlays over the past
half century.
Figure 1.
Federal Spending on Infrastructure as a Share of Nondefense

Expenditures, 1956-2006 (%)
12
Share of Total Federal Spending
10
Share of Nondefense Expenditures
8
6
4
2
0
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
2006
Source: The Congressional Budget Office
March 17, 2008
37
A potential negative
development for Dodds
financing bank would be a
public perception that
infrastructure is just another
word for pork
In 2004, total government infrastructure spending was 2.4% of GDP, roughly 8% less
than in 1956 and only 4.3% more than the 50-year low reached in 1998, according to an
August 2007 CBO study. Dodd has not announced plans for marking up his bill, the next
step. Speaker Pelosi plans for the House to consider short-term infrastructure spending
in the next stimulus bill, as well as Dodd's comprehensive idea. A concern about the
former would have to be whether Washington can first prioritize national needs. A
potential negative development for Dodds financing bank would be a public perception
that infrastructure is just another word for pork.
As policymakers begin to reverse decades of under-investment, a recent McKinsey study
found that 85% of pending infrastructure projects are located outside OECD countries
($380 billion total pending). 1 Given that most of these projects are in developing regions,
McKinsey stressed that valuations have already run high. The consultants highlighted
that typical advantages of private equity financing should help investors realize a profit:
improved financial engineering and operational efficiencies gained through applying
proven technological expertise.
Infrastructure investment is
gaining attention as a crucial
element on any policymakers
must-do list
A decade of relative easy lifting in Washington (1997-2006) was marked by a generally

robust economy, favorable market conditions, and usually low geopolitical risks aside
from two quarters in 1998 and an uncertain, troubling two-year period (4Q01-3Q03)
punctuated by the start of wars and equity market retrenchments. That time has passed,
and the near-term Washington policy outlook points to a series of important choices that
will bear directly on the U.S. standard of living. Infrastructure investment is gaining
attention as a crucial element on any policymakers must-do list.
1
How investors can get more out of infrastructure, Robert N. Paltor, Jay Walder, and Stian Westlake. The
McKinsey Quarterly, February 2008, McKinsey and Company.
March 17, 2008
38
Commodities
An Inflation Hedge, but for How Long?
Michael Widmer
44-207-102-3513
michael.widmer@lehman.com
Investors often view commodities as purchasing power protection, and recent price
movements against inflation expectations support that view. Yet real price and return
calculations show an often tenuous relationship between commodities and inflation.
Michael Waldron
212-526-7108
michael.waldron@lehman.com
COMMODITIES CAN RISE IN TANDEM WITH GENERAL PRICE LEVELS,

BUT NOT ALWAYS
Crude and gold at best

represent imperfect hedges
against inflation
Commodities are often seen as a good inflation hedge. Economics can justify this, as a
period of strong GDP expansion is often accompanied by upward pressure on general
price levels (however, high aggregate demand is not the only factor that can drive
inflation). In addition, healthy economic performance also generates higher commodities
consumption, thereby normally inducing commodity price appreciation. As such,
markets often view commodities as an inflation hedge, which can help to protect the
value of those assets that are sensitive to a rise in general price levels.
Although the theoretical argument for using commodities to protect against purchasing
power losses certainly holds, Figures 1 and 2 illustrate that crude oil and gold represent,
at best, an imperfect inflation hedge, with prices deviating substantially from inflationneutral oil and gold quotations (which are calculated by inflating 1913 prices with the
U.S. headline consumer price index; hence, these valuations would maintain 1913
purchasing power) in the short to medium term.
Real returns are another way to look at the usefulness of commodities as an inflation hedge. If
commodities were effective in protecting against purchasing power losses, investors would
need consistently to earn positive real returns. Our calculations show that the picture is
somewhat mixed on that front as well. Although recent data have been positive, during the
past 20 years, investors have seen periods of both substantially above and below zero real
returns (Figure 3).
Figure 1.
Oil as an Inflation Hedge
US$/bbl
Figure 2.
Gold as an Inflation Hedge
$/oz
70
700
60
600
50
500
40
400
30
300
20
200
10
100
0
1913 1923 1933 1943 1953 1963 1973 1983 1993 2003
Nominal oil price
Inflation neutral oil price
Note: inflation-neutral oil price is calculated using the U.S. headline CPI
Source: Ecowin, Lehman Brothers
March 17, 2008
0
1913 1923 1933 1943 1953 1963 1973 1983 1993 2003
Nominal gold price
Inflation neutral gold price
Note: inflation-neutral oil price is calculated using the U.S. headline CPI
39
Figure 3.
Nominal and Real Return for WTI and LMEX during Different Periods
Period
WTI
LMEX
Nominal
62.0%
46.8%
198.0%
92.9%
-1.0%
Jan 2007-Jan 2008

Jan 2006-Jan 2007
Jan 2003-Jan 2008
Jan 1998-Jan 2003
Jan 1988-Jan 1998
Real
57.6%
40.3%
181.6%
80.1%
-40.7%
Nominal
5.7%
39.0%
214.7%
-3.2%
-19.1%
Real
1.3%
32.4%
198.3%
-16.0%
-58.8%
Note: LMEX is the London Metals Exchange price index.

Periods of divergence likely stem from differing underlying drivers between headline
inflation figures and commodity prices: issues specific to the commodities industry (e.g.,
supply disruptions) may not affect the wider economy, while general economic issues
may not necessarily be relevant for commodities.
Limited Commodity Feed into General Price Levels
Central banks have
been effective in damping
commodity pass-through
Market participants may also view commodities as a hedge against inflation insofar as
resources make up a substantial part of the overall consumer price index. Yet although
the power of central banks to influence the feed-through of commodities prices in the
headline inflation rate is limited, they have been successful during the past 25 years in
controlling inflation expectations and moderating, hence, the effect on core inflation
(Figure 4).
Inflation Expectations Affecting Commodities;
Will the Relationship Wither?
But currently, as inflation

expectations increase, so do
commodity prices
Figure 4.
Nevertheless, current U.S. monetary policy may have raised concerns about whether the
Fed is able and committed to tackle inflation to the same extent that it has in the past.
This is one of the key reasons we believe that inflation expectations have shown a 0.91
correlation with WTI price moves since January 1 (Figure 5). Base metals and gold have
also shown robust relationships of 0.63 and 0.47. Fundamentals, especially for base
metals, have strengthened substantially since the beginning of the year, which may
Oil Prices: Limited Effect

on U.S. Core Inflation
Figure 5.
% y-o-y
% y-o-y
200%
150%
100%
50%
2.5
14%
115
2.4
12%
110
10%
105
8%
100
2%
0%
-100%
71 74 77 80 83 86 89 92 95 98 01 04 07
WTI (lhs)
March 17, 2008
US core inflation (rhs)
16%
4%
-50%
Indexed, 1 November 2007 = 100

120
6%
0%
Correlation between Inflation,

Oil Prices, and LMEX
2.3
2.2
2.1
95
2.0
90
85
Nov-07
1.9
Dec-07
Jan-08
Feb-08
Mar-08
WTI (lhs)
LMEX (lhs)
5-year breakeven inflation (rhs)
Note: Breakeven inflation is calculated as the difference between the yields on

nominal and inflation-indexed bonds.
40
explain the lower correlation with inflation. But the relationships weaken if one goes a
bit further back to November 1, when the oil, base metals, and gold correlations drop to
0.62, 0.27, and -0.23, respectively.
Doubts about central bank
credibility drive prices, but
fundamentals still matter
March 17, 2008
The crucial questions remain when the recent strong relationship might break down or
when investors will revise their perception of needing an inflation hedge. Given the
recent high importance of inflation expectations for crude oil, any reversal may lead to
volatile pricesespecially in the petroleum complex, which continues to display a mixed
picture between weaker short-term and stronger long-term fundamentals. Base metal
prices may be somewhat less exposed, because fundamentals still seem relatively strong.
Still, as market participants question central bank credibility, inflation effects on
commodities may persist through 2008.
41
Currencies
Ongoing Risk Aversion Should Sustain Yen Rally
The deterioration in financial markets remains a big upside risk to the yen, especially
since the Japanese have not yet retreated from global capital markets. That said, the
effect of yen strength and Nikkei weakness on Japans economy will be significant
Jim McCormick
44-207-103-1283
jmmccorm@lehman.com
RISK PREMIA NORMALIZATION HAS MORE ROOM TO GO
Stephen Hull
44-201-03-2246
stephen.hull@lehman.com
On the surface, this should have been a good week for policymakers. The Feds newly
announced measures to address liquidity shortages in the banking system were
reasonably aggressive and more directly aimed at easing the intense pressures in global
credit markets. And yet by time of print, the subsequent risk rally had already fizzled out
on a combination of surging oil prices, a plunging dollar, and persistent credit market
stress. This trend of diminishing returns from Fed policy responses should be alarming,
but, unfortunately, not surprising. In the end, the macro backdrop of likely U.S. recession
and stubbornly high global inflation means that we are likely in for a prolonged period of
global risk premia normalization from the multi-year lows of 2007. At the same time, the
longer this credit-driven crisis persists, the greater are the risks that the effect on the
global economy (rather than just the U.S.) will be bigger than many currently think.
YEN RISKS STILL SKEWED TO THE UPSIDE, PERHAPS SIGNIFICANTLY
Dollar fall is gaining pace
Figure 1.
As we have noted before, a persistent rise in global risk premia would be most beneficial
to the yen (and to a lesser degree, the Swiss franc). Now, with USD/JPY having traded
below 100 and rapidly approaching our end-2Q target of 95, the two key near-term
questions are whether intervention by the Japanese is far off and whether we should be
thinking about an even lower terminal target for USD/JPY. On intervention, we have
long believed that Japanese policymakers would not draw a line in the sand at 100, in
part because the trade-weighted yen remained weak, but also because Japans
Global Risk Premia and the Japanese Yen
Index
120
Long-run MARS
Index; inverted
-2.0
110
-1.5
Trade-w eighted yen

Global risk premium (rhs)
Figure 2.
yen trillion, 3mma

2.5
-0.5
90
Start of
quantitative
easing
Current account
2.0
Trade balance
-1.0
100
Japans External Accounts
1.5
0.0
80
0.5
70
1.0
60
1.5
92
94
96
98
00
02
04
06
1.0
0.5
08
0.0
85
Source: Lehman Brothers; BIS; Reuters; Bloomberg.
March 17, 2008
87
88
90
92
94
96
98
00
02
04
06
Source: Lehman Brothers; Japanese Ministry of Finance
42
chairmanship of the G7 would preclude any such move. But as financial market stress
has increased, we see a chancealbeit a very small onethat G3 policymakers may
view a collapse in USD/JPY as a further, unnecessary source of stress for markets.
In terms of whether 95 is too timid a terminal target for USD/JPY, the answer is: quite
possibly. The case for yen strength has first and foremost been a capital flow storyand
one that would ultimately be driven by Japanese investors. Since the beginning of
quantitative easing back in 2001, Japanese capital has been pouring into foreign assets in
record amounts. And while it is not easy the get a precise reading on the size of these
outflows, the fact that Japans current account surplus has ballooned relative to the trade
account argues that the stock of Japanese external assets is enormous (remember, the
only difference between the two balances is income repatriation from overseas assets;
Figure 2). More important, all indications would seem to suggest that Japanese investors
have not begun retreating from global capital markets. Indeed, since the start of the Fed
easing cycle, bond outflows have surged (Figure 3). At the same time, uridashi issuance
in recent months has been close to record levels. If Japanese investors do begin to
repatriate some of these assetsa non-negligible risk given the current state of the global
economyfurther upside risk to the yen could be sizable. We will maintain our 95 target
for end-2Q, but acknowledge that the downside risks are growing.
FINANCIAL CONDITIONS HAVE DIVERGED MARKEDLY IN THE G10
Financial conditions are
tightening in most of the world
Figure 3.
Further out, the persistence of financial stress has increased the chances that the spillover
from the U.S. to the rest of the world could be substantial. Figure 4 compares the changes
in policy rates since last July with the changes in a simple measure of financial conditions
that adds the effects of exchange rates, equities, and longer term interest rates. A few
points are clear. First, even with the aggressive cuts by the Fed, global financial conditions
have not eased much, as equity markets have fallen and most borrowing rates have risen.
More to the point, the effect of the dollars fall and stress in global markets has had a
substantial impact on certain economies conditions. The most notable is Australia, where
our measure suggests some 200 bp of tightening when the RBA has raised rates by only
half that amount. Scandinavia has also witnessed quite a lot of tightening. Meanwhile,
Recent Capital Flow Trends in Japan
yen trillion; cumulative from

start of fiscal year
14
Start of
12
Fed easing
cycle
10
Japanese outflow s to
foreign bonds
Foreign inflow s to
Japanese stocks
Figure 4.
bps
250
200
150
50
2
0
-2
-4 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52
Weeks from start of FY
Source: Lehman Brothers; Japanese Ministry of Finance
March 17, 2008
Policy rate change
FCI
Tighter
100
Changes to Policy Rates and Financial

Conditions since End-July 2007
-50
-100
-150
Looser
-200
-250
USD CAD GBP EUR JPY NZD CHF SEK NOK AUD
Source: Lehman Brothers; Bloomberg
Note: the FCI includes policy rate, 3-month LIBOR, long-term corporate rate,
equity returns and exchange rate; effect of exchange rate and equity market
dependent on openness of economy and size of equity market.
43
Canadas 100 bp of easing has been nearly fully offset by currency strength and financial
market stress. Perhaps most important, if there is one reason to doubt the sustainability of
the yens rally (we still look for modest yen weakness in late 2008), it is the effect it is
having on Japans financial conditions. By now, conditions have tightened by 100 bpat
a time when inflation pressures are muted and growth is slipping fast.
March 17, 2008
44
U.S. Interest Rates Strategy

How Deep Are the Feds Pockets?
Amitabh Arora
212-526-6566
amitabh.arora@lehman.com
Priya Misra
212-526-6566
prmisra@lehman.com
Kurush Mistry
212-526-6566
kmistry@lehman.com
The Feds balance sheet is limited; thus, further actions need careful evaluation. The Feds
next steps, besides easing, are likely to focus on broker-dealers, could possibly include
other AAA assets, but would continue to be primarily financing rather than purchase
transactions, in our opinion. Any managing of near-term Funds expectations is likely to be
done through Fedspeak rather than extending the duration of the SOMA portfolio.
FED ACTIONS SO FAR: FIX FINANCING FIRST
Most economists would agree that the aggressive Fed easing policy over the past few
months has not been as effective as it would have been historically. This is because the
transmission mechanism of the Feds rate policy into borrowing costs is impaired by
stress in capital markets. The decline in Treasury rates has been more than offset by a
widening in corporate and mortgage spreads. Indeed, as we examined in a recent article,
borrowing costs for the non-financial sector have actually gone up since the Fed started
easing, even though 5-year Treasury rates have declined by more than 200 bp. It is
natural, therefore, for the Fed to adopt unconventional means to help fix the transmission
mechanism. We discuss the unconventional actions that the Fed has already taken and
what further steps we think it is likely to take.
Let us begin with an examination of the actions that the Fed has taken so far. In
December, the Fed embarked on a series of steps to help financing for spread products in
general. The motivation seemed to be to reduce the probability of a liquidation of assets
held by leveraged entities because of a lack of access to financing. The first step was the
Term Auction Facility (TAF), which provided term financing to depository institutions
against a wide range of collateral. This was followed by an enhanced term repo facility
for primary dealers against agency debt and agency MBS. And last week, the Fed
announced the Term Securities Lending Facility (TSLF), which provided primary dealers
the ability to effectively finance their agency debt, agency MBS, or AAA private label
MBS (by exchanging it for Treasury collateral in repo).
There appears to be a natural progression in the steps so far undertaken by the Fed.
March 17, 2008
Size: The initial size of the TAF was a combined $40 billion in December, which
was increased to $60 billion in January and increased again to $100 billion in March.
In addition, the Fed announced $100 billion in 28-day term repo and $200 billion in
the TSLF. Thus, the total financing committed by the Fed has increased from $40
billion to $400 billion. In addition, the TAF-like facilities offered by counterpart
foreign central banks have also been increased.
Counterparty: The range of counterparties that the Fed is seeking to help finance
has broadened. While the TAF program provided financing only to banks, the
recently introduced term repo and TSLF provide access to primary dealers.
Assets: The assets eligible for repo-like transactions have recently been broadened
(in the TSLF program) to include AAA private label MBS.
Haircuts: Effective haircuts have also been reducing over time. Haircuts at the TAF
were the same as the discount window, but required a 50% overcollateralization
(thus effectively doubling the haircut). While haircuts for the TSLF have not yet
45
been announced, we expect the effective haircut to be lower than the TAF because
there is no overcollateralization requirement.
POTENTIAL NEXT STEPS FROM THE FED
Not That Much More Room for Action,
Especially Given the Size of Leveraged Entities
The total balance sheet of the Fed stood at about $880 billion as of March 12. Thus, so
far, the Fed has committed around half its balance sheet to improving financing
conditions for banks and primary dealers. While the remaining ~$500 billion may seem
large, it needs to be viewed in context of the assets under financing stress. The Feds
current balance sheet 1 is rather small compared with the size of spread assets held by
leveraged entities (brokers and hedge funds).
Interestingly, given the rapid growth in leveraged entities over the past ten years, the
Feds balance sheet is now only 10% larger than that of leveraged entities non-Treasury
holdings, while it was four times their size in the early 1990s. Of course, the Fed doesnt
have to match its balance sheet with that of the leveraged entities in order to be
significant, because a small amount of supporting flows could be sufficient at the
margin. The remaining ~500 billion of balance sheet is, nevertheless, very valuable and
has to be used in a manner most likely to support the functioning of the markets. It
becomes critical for the Fed to weigh carefully the costs and benefits of the alternative
courses of action, which we analyze in the next section.
We Analyze Potential Further Steps under Various Parameters
Ease, but Accompanied by Unconventional Measures
The Fed has significant further room to ease, given that the funds rate is currently only at
3%. However, two factors preclude solely easing-driven measures. One, easing takes
time to work through the system and does not do much to directly address the more
Figure 1.
Limited Ammunition
Compared with Leveraged Entities
Figures 2. Broker-Dealers Are More Significant Today
10%
450%
400%
8%
350%
300%
6%
250%
200%
4%
150%
100%
2%
50%
0%
Mar-90
Mar-94
Mar-98
Mar-02
Mar-06
Fed Assets / Dealer Spread Assets

Source: Federal Reserve Flow of Funds. Feds balance sheet versus brokerdealer held credit market instruments (ex-Treasuries)
1
March 17, 2008
0%
Mar-90
Mar-94
Mar-98
Mar-02
Mar-06
Dealer Assets / Bank Assets

Source: Federal Reserve Flow of Funds. Broker-dealer held versus commercial
bank held credit market instruments (ex-Treasuries)
Note that if there was no longer room to ease, the Fed could then expand its balance sheet, ie quantitative easing
46
pressing funding concerns that can disrupt financial market functioning. Second, easing
too far would likely cause a significant dollar drop, thus contributing to inflation,
something that the Fed would not like to see (notwithstanding Fridays benign CPI print).
While we think that the Fed will ease to 1% (in line with our economics groups call), in
our opinion, it is more likely to adopt further unconventional measures than to ease more,
or more rapidly.
SizeLimited
As noted above, the Fed has limited room to increase its financing alternatives, as it
would not want to expand its balance sheet currently. In addition, it would want to keep a
reasonable proportion of its assets in liquid, relatively less risky instruments such as
Treasuries. The total size of further alternatives would thus likely be limited to around
$300 billion (assuming that it keeps $150 billion in Treasuries). Of course, it could shift
the composition of its initiatives to different counterparties or asset classes.
CounterpartiesFocus on Brokers
While banks provide around 25% of the credit to the non-financial sector, they are not
subject to as much liability rollover risk as broker-dealers. This is primarily because a
large portion of banks funding (~60%) is through a relatively stable deposit base, which
is FDIC insured for the most part. 2 On the other hand, close to 80% of broker-dealer
liabilities are uninsured and subject to rollover risk. 3 In addition, dealer balance sheets
have grown rapidly relative to those of banks and are close to 10% of the latter,
compared with 3% in the early 1990s. The increased significance and higher borrowing
risks of dealers suggest that further efforts should be concentrated toward them. Indeed,
the progression of Fed actions, from the TSLF to supporting a specific investment bank
indirectly through the discount window, gives clear signals in this direction.
Rates versus Spread Product
A large proportion of borrowing in the economy happens not at short-term rates (which
the Fed more directly controls), but further out the curve, at, say, the 5-year point. A very
steep curve could thus be an impediment to the Feds transmission mechanisma
possible solution could be for the Fed to extend the maturity of its SOMA (System
Open Market Account) portfolio. However, 5-year Treasury yields have declined a
sizeable 250 bp since the Fed started easing. The culprit keeping borrowing costs high
has been spread widening and not so much a steep curve. The Fed would rather
concentrate its limited balance sheet on supporting spread product. If it also wants to
keep rate expectations low for a few years, it could use statement language or Fedspeak
(similar to considerable period) to achieve that result.
Risky, Effective Assets
Given its limited balance sheet, Fed actions could arguably be more effective through
supporting more risky assets. However, two factors could alter this rather simplistic
conclusion. First, the Fed does not want to take on undue credit risk. Since the 1950s, the
Fed has held a maximum of 6% of its balance sheet in agency debt/MBS. Second, the
most stressed assets would, by definition, be contributing little to credit extension, as
there would presumably be much less new origination in them. Supporting these assets
would improve the health of the financial system in general but not borrowing costs
directly. The Fed would probably use some mix of these two motivations 1) supporting
2
Only 30% of bank deposits are large; therefore, only partially FDIC insured. Source: Federal Reserve Flow of
Funds as of 4Q07
3
Security repos, security credit, and from banks.
March 17, 2008
47
the financial system indirectly, and 2) lowering borrowing costs directly for specific,
stressed, but relatively functioning markets.
The recent TSLF announcement seems to be along these lines, as it would effectively
finance agency MBS and AAA non-agency MBS. The agency MBS market is effectively
the only market through which mortgage loans are being extended. The significant net
issuance and a supply-demand imbalance have caused agency MBS spreads to widen
significantly, and dealer inventories of these have doubled from more normal levels to
around $60 billion currently. Supporting this market is along the lines of the direct
support above. By contrast, non-agency origination (securitized or otherwise) has been
almost absent in the past few months, and Fed action in this sector is more in the vein of
indirect support.
Further expansion of acceptable asset classes should take the same approach, and we
believe that other types of AAA assets/tranches could be the next candidate(s) for
expansion. AAA CMBS and AAA CLOs are two that come to mind.
Buying (Instead of Financing) Would Have More of an Impact, but Is Unlikely
The Feds buying (instead of financing) assets would have the most significant effect on
asset valuations and, thus, on stabilizing the system. Buying would involve taking on
much more credit risk than financing, because the latter has a haircut, is also backed by
counterparty credit, and is exposed only to daily mark to market. For example, the daily
price volatility on FNMA 5.5 TBAs has recently been around 60 centsthis is what one
could lose on an outright position in a day. Assuming the discount window haircut of 2%
for agency MBS, it would require a 4-sigma move to sustain the same 60-cent loss on a
collateralized position (even assuming that the counterparty is worth nothing).
The Fed can buy non-Treasury debt(Agency Debt and Agency MBS) for its portfolio, but
has done so rarely and in small size. The largest holding of agency debt/MBS by the Fed
has been 6% of its assets, in the late 1970s. The reasons for this could be that the Fed
seeks to minimize the effect of its operations on specific credit sectors and also does not
want to assume undue credit risk. We do not expect the Fed to buy non-Treasury
securities except as a last resort and, even then, believe it would restrict purchases to
agency MBS. For remaining assets, the market will likely have to be satisfied with
repo/TAF-like operations.
And the Winners Are
To conclude, the Fed will likely continue to ease the funds rate, but supplement it with
further unconventional measures. These measures are likely to focus more on brokerdealers than on banks, could possibly include other AAA assets such as CMBS and CLOs,
but would continue to be primarily financing rather than purchase transactions (except
possibly for agency MBS). Any managing of near-term funds expectations is likely to be
done through Fedspeak rather than extending the duration of the SOMA portfolio.
Market Implications/Positioning
Duration/curve: Further unconventional measures, particularly targeted along the

above lines, should help mend the transmission mechanism more quickly and, thus,
hasten an eventual recovery. However, despite these measures, we still think that the
Fed would need to ease to 1% and keep rates low.
-
March 17, 2008
Positioning: We favor a long position in the front end and stay in steepeners.
Note, however, that the more unconventional and the larger these measures get,
48
the weaker our duration and curve views will be, provided, of course, that the
measures are likely to succeed.
March 17, 2008
Financing rates: As the Fed shifts to lending against more non-conventional

collateral, we would expect Treasury GC to cheapen significantly (this would add to
existing cheapening pressure from bill supply). Agency MBS should finance better
once the TSLF comes into force, as should other assets that the Fed supports.
Swap spreads: Further Fed actions should have a tightening effect on spreads,
particularly in the front end. This would be directly from a cheapening in GC due to
Treasuries lent out from the SOMA. Over the longer term, as pressures on balance
sheets subside, we would expect the spread between LIBOR and Fed funds to
compress.
Realized volatility: is unlikely to subside anytime soon, as underlying economic data

should continue to be choppy and there is limited risk appetite among financial
intermediaries. In addition, the Fed actions themselves could promote more volatility
in the short term.
49
CORE VIEWS
Recommended Positioning
Suggested Trades
Strength of
Conviction
View Held
Since
Macro
Duration
Systematic View: Neutral: The duration scorecard has

turned neutral, from risk aversion and momentum signals.
Discretionary View: Long 2-year: The market is too
aggressive in pricing in rate hikes in 2009we think the
Fed will need to keep rates low for a while.
Curve
Steeper: We like a forward 1s-5s steepener, conditional on

a rally, as we think that the 80 bp of tightening priced in for
2009 is too aggressive and at odds with a prolonged
slowdown.
3/13/08
Long 2-year OIS or 2-year
Treasuries
1y1y 1y5y 25 low, conditional
steepener,
50%
3/13/08
100%
3/6/08
(Current 138, Target 165)
Breakevens
Level
Wider: Front-end breakevens are understating the

Long 1/09 Breakevens (Energy
persistence in core inflation and the possibility of high food Hedged)
inflation in the second half of the year.
(Current: 273, Target: 275)
100%
09/20/07
Curve
Flatter: We expect the 3s-10s breakeven curve to flatten as Long 4/10s versus 7/17 breakevens
either the benign core inflation outlook priced in the front
(Current:34, Target: 20)
end should be reversed or, if inflation declines as the
market expects, 10-year breakevens should tighten. Dovish
Fed risk should be hedged with ED steepeners.
100%
9/26/07
Level
Long 3.5% 2/18s versus matchedWider: 10-year spreads have retraced the entire move
date swaps
wider since mid-February, while other spread products
have underperformed. Hence 10-year spreads appear too
(Current: 71.1, Target: 81.0)
tight relative to other forms of risk premium. We remain
neutral in front-end spreads. The TSLF seeks to lend out
as much as $200 billion in Treasury GC. Hence, we expect
GC to cheapen, but the risk aversion demand for bills may
continue for some time. Hence, we wait to initiate front end
spread tighteners until we see a sustained cheapening in
GC or signs that bank balance sheets are less constrained
(which should help tighten L-FF).
50%
3/13/08
Curve
Neutral: We are wary of fading the 5s-10s spread curve

flattening relative to duration extensions because of repo
specialness; any return to convexity paying needs could
continue to flatten the spread curve, depending on the
nature of the partial durations' behavior as mortgages
extend.
Swap Spreads
11/15/07
Agencies
Level
Long: 5-year agency asset swap valuations should richen

with lack of supply, particularly as the recent earnings
releases indicate the capital constraints, which will mean
that growth will be concentrated in the guarantee business.
Also, we expect 2-year agencies to outperform Treasuries.
Concerns about L-FF should not affect agency nominal
spreads as much, and we expect GC to cheapen with
increasing bill supply and the Fed actions (TAF, TSLF).
Curve
Neutral. The underperformance of the 5-year sector on the

2-5-10 agency and swap spread flies has stopped us out of
the 5s-10s agency-Treasury curve steepener. If
normalization begins in earnest, we would look to reinitiate
further in the curve owing to repo considerations in the 5year sector.
Callables
Callables: Own against mortgages. Demand-supply

technicals should be negative for mortgages, while agency
debt benefits from reduced supply.
March 17, 2008
Long FHLMC 12/12 on asset swap

(matched-date)
50%
2/28/08
50%
12/21/07
(Current: 15, Target: -15)

Long FHLMC 4.125% 11/09s versus
T 3.125% 11/09s
(Current: 74, Target: 43)
3/5/08
Long 10NC1 against current coupon

passthroughs.
1/11/08
50
Volatility
Vega
Biased short. We believe 1y2y should cheapen further, as it

appears rich relative to the term premium
Gamma
Short gamma in 1m10y swaptions,

Short: Our signaling model implies low risks to short
gamma, mainly because of decline in MBS index convexity delta-hedging daily
and decline in mortgage applications. We scale up the
notional of the short gamma trade to 75% conviction.
75%
12/6/06
Mortgages
Basis
Neutral. Supply/demand technicals are not favorable.

We expect increased supply driven by non-agency to
agency refinancings. However, we are shifting to a
neutral positioning because of recent underperformance.
Neutral to the basis
Coupon
Stack
Favor up-in-coupon. Slowing HPA and tighter

underwriting standards means prepayments should slow,
particularly on weaker credit collateral.
Buy 6.5s vs. 5.0s
100%
12/12/07
Favor Trust IOs and 15-year mortgages
Buy FHT 245 IOs vs.TBA
100%
12/12/07
Sectors
March 17, 2008
Buy DW 5.5/FN 6.0 swap
2/22/07
51
TRADE REVIEW
Return Statistics
Total Equity ($mn)
YTD P/L ($000)
YTD % ROE
1-Week P/L ($000)
1-Week % ROE
150
50
-306
-1,470
-0.24
-2.94
-420
-789
-0.32
-1.58
Position Size
1-week
Since Initiation
Discretionary Positions
Systematic Positions
Marked as of 3/13/2008
Start Date
Level
Initial or
Current Trades
(12/17/07)
$ P/L
Current
Target
(Stop loss)
Equity
($mn)
Lev.
P/L
(bp)
(000s)
P/L
(bp)
$ P/L
(000s)
% ROE
2.12
1.62
12
12
89, 2.95
95, (61),
for 1y2y at
<=2.85
13
15
-7
-136
103
0.8
Macro
Duration: Long 2y OIS
3/13/08
1/23/08
Curve: 1y2y 1y5y Conditional Steepener , using 25 low
receivers
2.12
76 bp,
2.85
1y2y
TIPS
Long 1/09 Breakevens (Energy Hedged)
12/17/07
217
273
275bp
(-10% ROE)
21
63
69
1,100
15.7
2s-10s Breakeven Curve Flattener (Energy Hedged)
12/17/07
34
36
20bp (-10%
ROE)
29
72
-2.6
0.1
3/13/08
71.1
71.1
81 (-10%
ROE)
20
0.0
Long 5-yr Agencies on Asset Swap (Long FHLMC 4.625%

12/15/12 versus matched-date swaps)
2/28/08
0.0
15.1
-10 (-15%
ROE)
20
-56
-556
-56
-552
-11
Long 2-yr Agencies versus Treasuries (Long FHLMC

3.125% 11/09s vs. T 4.125% 11/09s)
12/21/07
58.1
74.5
43 (-10%
ROE)
30
5.2
82
-20
-251
-5.0
Duration View Turned Neutral
2/21/08
4.49
4.24
NA
7.5
-197
-737
-189
-697
-14
Short Gamma (1m10y Straddles), Delta-Hedged Daily, 75%

risk
12/17/07
(-15%
ROE)
9(time
average:
4.4)
-6.9
-52
-137
-521
-11.7%
Swaps
Initiated on 3/13: 10-year Swap Spread Widener (Long 3.5%
2/18s versus matched-date swaps)
Agencies
Systematic
Funding costs are assumed to be Fed Funds. Details on the trade weightings are provided when the trade is initiated. For P/L purposes, the portfolio is marked every Thursday at 3:00 pm. For the leveraged portfolio
statistics, total face amount of the long position = equity x leverage. P/L (bp) gives the P/L of the position excluding gains on equity held against the position, while P/L ($) gives the P/L of the position including gains on equity
held against the position. Trades carried over from 2007, rather than opened anewinitiation bid/ask was charged in 2007 and is not recharged above. Past performance is not an indicator of future performance. For
systematic trades, since initiation is cumulative performance for the entire YTD
March 17, 2008
52
Summary of Previous Recommendations

Level
Closed and/or Retired Trades
5s-10s Agency-Treasury Curve Steepener (Long FHLMC 4.625% 10/12s

vs. FHLMC 5% 4/17s, both vs. 4.25% 9/12s and 4.75% 8/17s Treasuries)
Short 2-yr Nominal Swap Spreads
Short 10y10y vs 3y10y, Beta Weighted
Long 10-yr Agencies on Asset Swap (Long FHLMC 5.125% 11/17s
versus matched-date swaps)
EDM8EDM9 Rally Steepener
Short 5y5y TIPS vs. Nominals (75% beta), long CDXIG
1y2y 1y5y beta-weighted steepener in swaps
Holding Period
P/L (bp)
Initial
Termination
Total
-10.9
-26.6
-71
12/17/07-3/5/08
81.8
95.9
12/18/07 2/28/08
19.1
14.5
-12.3
12/17/07-3/5/08
12/17/07-2/28/08
Leveraged Portfolio Statistics

Equity
$ P/L
($mn)
Lev.
(000s)
% ROE
5
20
-662
-13
-48
40
17
30
-681
-14
38
2,722
7.0
-128
16
20
-1,241
-25
1/29/08 2/19/08
32
46
-1.9
33
-36
-0.6
12/18/08-2/15/08
B 245, CDX 76
B 258, C: 141
65
10
20
1,362
13.6
12/23/08-2/14/08
76
89
49
16
245
8.2%
Short 1y2y Real Rates
12/29/08 1/22/08
108
49
-43
12
12.7
-2308
-19%
Long 1/09 Breakevens (Energy Hedged)
09/20/07 12/17/07
164
217
-19
21
-209
-3.0%
34
+0.6
29
84
1.2%
38.5
130
5.1%
-1.6%
09/26/07 12/17/07
57
Short 1y2y hedged with EDH08/EDZ08 curve and the term premium
11/27/07 12/7/07
20
17
13
2.6
Short Gamma (1m10y Straddles), Delta-Hedged Daily
12/6/07 12/17/07
-78
25
-415
Short Gamma (1m10y Straddles) Unhedged

Long 10-yr Agencies on Asset Swap
12/14/07 12/17/07
-96
-96
-139
11/7/07 12/17/07
-10.5
-13.4
36
20
386
7.7%
5s-10s Agency-Treasury Curve Steepener
10/5/07 12/17/07
3.6
-10.9
-27
20
-222
-4.4%
67
22
25
22
1215
4.9
2s-10s Breakeven Curve Flattener (Energy Hedged)
11/21/07-11/27/07
79
Systematic Short (50% risk): Pay on 10y swaps
11/02/07-11/15/07
4.97
4.89
-62
-175
-2.9
2s-10s Swap Spread Curve Steepener
09/21/07-11/15/07
2.3
-12.6
-103
3.5
14.3
-490
-14
79
-51
30
-733
-15
-532
-8.9
Beta-weighted 2s10s flattener in swaps
09/24/07-11/21/07
43
Systematic Short (50% risk): Pay on 10y swaps
9/27/07-10/25/07
5.20
4.95
-184
Discretionary Short (50% risk): Pay on 10y swaps
10/12/07-10/23/07
5.30
5.02
-210
-621
-10.4
9/20/07-11/01/07
67
62
-40
12.5
-285
-2.3
10/2/07-10/29/07
-28.7
-30.8
-6.3
1.6
94
-100
-6.3
10/5/07-10/11/07
10
2.6
38.5
112
4.3
Long 2-yr Agencies vs. Treasuries
1-year forward 2s10s steepener in swaps

Short 2s3s5s fly (%/10s vs. 9/09s and 9/12s), regression weighted
Short 1y2y hedged with EDZ07/EDU08 curve and the term premium
5s-10s Agency Asset Swap Spread Curve Flattener (Long 5% FNMA 5/17s
versus 5.125% FHLMC 7/12s, both on asset swap)
Long 2y10y vs. 5y10y, 100-bp Low; Sell 1m10y Gamma
8/30/07-9/28/07
8.4
3.7
16
25
182
3.6
12/14/06-9/17/2007
-2.2
3.7
35
10
15
926
9.3
Long 10-yr Agencies vs. Swaps (Long 5.375% FNMA 6/17s on asset swap)
8/14/07-9/13/07
-8.2
-14.2
49
20
515
10.3
12/6/06-8/27/07
2.0, 5.0
5.7, 10.4
-40
50
-651
-17
21
0.9
20
192
3.8
5.51
N.A.
-280
-7.0
48.4
25 (45)
10
11
-760
-7.6
251 B/E,247 Real

64.3
9.5
55.9
260 Real (-10%)

-32
-28
-16
5
4
4.5
4
15
25
44
20
338
-332
-540
-109
+6.8
-8.3
-13
-2.7
Long 8.75% 5/17s, 8.875% 2/19s vs. 9.25% 2/16s on Asset Swap
2s-5s Agency Spread Curve Flattener (FHLMC 7/11s vs. 5/09s, vs. Treasuries)
12/6/06-8/14/07
13.1
Systematic Short: 1/3rd of total position
7/19/07-07/31/07
5.72
1yfw 2s-10s Flattener in swaps
1/25/07-07/26/07
1/25/07-07/26/07
7/5/07-7/10/07
5/29/07-6/14/07
5/8/07-6/7/07
Long 5y5y Real Rates (60% Hedged)

10-yr Swap Spread Tightener (Short 4.625% 2/17s vs. matched-date swaps)
Short 5/30s vs. 11/22s on asset swap
10-yr Swap Spread Tightener (Short 4.625% 11/16s vs. matched-date swaps)
March 17, 2008
38.5
240 B/E, 248 Real
60.1
7.5
52.6
53

Short the 2s5s10s PCA Fly using Olds (1/12s vs 1/09s and 11/16s)
3/21/07-5/30/07
-29.4
-27.4
7.8
75
275
6.9
Long 2-yr Swap Spreads (Long 4.75% 2/28/09s vs. matched-date swaps)
Long 6m1y 25-Wide Payer Spread
4/26/07-5/23/07
12/6/06-5/23/07
38.0
7.1
39.0
25.0
0.3
17.3
1.5
5
100
100
10
996
0.6
19.9
Short 10y by paying in swaps (halved on 4/26)
3/29/07-5/17/07
5.17, 5.28, 5.20
5.25
1.1
29
0.6
Long FNMA 5.125% 4/15/11 vs. Matched-Date Swaps

Long FNMA 4.625% 5/01/13 vs. Matched-Date Swaps
Short 3m1y versus 1y1y Swaptions
2s Spread Tightener (Short 4.875% 1/09s vs. matched-date swaps)
12/26/06-5/11/07
12/26/06-5/11/07
3/19/07-5/16/07
3/21/07-4/16/07
-13.7
1.9
26, 61.25
39.4
-16.2
-2.3
22.72, 54.23
39.1
20
32
-0.5
0.0
4
4
10
2.5
25
25
100
100
279
401
-50
10
7.0
10.0
-0.5%
0.4
Long 2/36 Ps vs. 2.31 Ps, Term Prem. Hedged 7% DV01 5/11 5/16 Steepener
12/26/06 -3/22/07
-10, 4.0
-5.9, 11.6
-33.5
4.5
22.2
-279
-6.2
2s-5s Steepener 1-year Forward; Hedge with Short EDZ7, 25%
1/16/07-3/13/07
8.0
14.5
-3.2
20
50
-158
-0.8
Long 3.375 12/08 vs. 4.75% 12/08
1/16/07-3/2/07
-1.3
-2.0
1.5
0.75
267
15
2.0
10s Spread Tightener (4.625% 11/15/16 on Asset Swap)

Short 8/22 March Net Basis; Long 34 104 Puts, 79 103 Puts
2s-10s Spread Curve Flattener (Long 4.625% 10/31/08 vs 4.625% 11/15/16,
Both Legs on Asset Swap)
Short 5y10y Delta-Hedged (Halved, Removed 2yfw 5s-10s Steepener 1/16)
2/13/07-3/1/07
12/6/06-3/1/07
49.6
4.9
52.3
1.1
-17
3.4
5
4
20
25
-125
83
-2.5
2.1
12/26/06-2/13/07
13.0
11.8
-1.1
20
26
0.5
12/14/06-2/6/07
80.2
71.5
185
10
1440
19
1/25/07-2/5/07
5.28
5.20
17
50
408
8.2
Long 5y in Swaps, Hedged w/ 20% Beta-Wtd. 5y Spread Widener

Long FNMA 6.625% 9/15/09 on Asset Swap
12/6/06-2/1/07
-15.0
-17.5
8.4
25
116
2.9
Short 1y10y, Delta-Hedged Daily; Receive 10y Swap Spread Hedge

Long 1/10 TIPS Breakeven (60% Hedge Ratio)
Short Front-End Eurodollars ( EDZ6); 9/29 Tripled Position Size
12/14/06-1/29/07
12/6/06-12/21/06
12/6/06-12/18/06
74.0, 45.6
BE 226, Real 220
5.348; 5.325(9/29)
70.5, 52.8
BE 221, Real 233
5.365
-101
-128
0.3
10
8
10
10
9
360
-954
-1030
130
-9.5
-13
1.3
Short 5y5y
12/6/06-12/21/06
5.06
5.20
50
13.5
85
444
3.3
Funding costs are assumed to be Fed Funds. Details on the trade weightings are provided when the trade is initiated. For P/L purposes, the portfolio is marked every Wednesday at 3:00 pm. For the leveraged portfolio
statistics, total face amount of the long position = equity x leverage. P/L (bp) gives the P/L of the position excluding gains on equity held against the position, while P/L ($) gives the P/L of the position including gains on equity
held against the position. Trades carried over from 2006, rather than opened anewinitiation bid/ask was charged in 2006 and is not recharged above. Past performance is not an indicator of future performance.
March 17, 2008
54
Treasury Inflation-Protected Securities:

Are Breakevens Understating Inflation?
Anshul Pradhan
212-526-6566
apradhan@lehman.com
We discuss a framework for extracting inflation expectations from breakevens that

accounts for changing liquidity conditions. The increasing spread between on-the-run
and off-the-run Treasuries suggests a preference for more liquid securities, which may
imply that breakevens are understating inflation expectations. We recommend
expressing the high inflation view in the front to intermediate part of the curve.
QUANTIFY THE EFFECT OF LIQUIDITY
How will changing liquidity

in the market affect
TIPS valuations?
The resurgence of the turmoil in the credit market, as implied by widening high grade
credit spreads, bank CDS, and higher L-FF basis, has caused market participants to rush
towards the safest asset: U.S. government paper. And even within the Treasury universe,
there is a preference for on-the-run securities, as suggested by widening on-the-run/offthe-run spreads (using CMT data from Lehman Brothers for the off-the-run spline and
Federal Reserve data for the on-the-run spline) (Figure 1). Thus, we think it is reasonable
to assume that TIPS may also be losing some premium, causing breakevens to understate
inflation expectations.
The liquidity premium

for on-the-run Treasuries
is increasing
The Federal Reserve Bank of Cleveland has developed a framework to quantify this
liquidity adjustment. It assumes the spread between on-the-run and off-the-run nominal
Treasuries (referred to henceforth as the liquidity premium) to be a proxy for the relative
liquidity of TIPS versus nominal Treasuries. The hypothesis being that relative liquidity
across products should be correlated, i.e., if on-the-run nominals are gaining liquidity
premium versus off-the-run nominals, then nominal Treasuries should also gain a
liquidity premium versus TIPS, the least liquid of the three. Figure 1 shows that the
liquidity premium in on-the-run nominals has increased sharply in the recent crisis.
Current Crisis Leading to

Higher Liquidity Premium
0.45
0.40
Figure 2.
Spread betw een Off-the-Run

and On-The-Run nominal yields
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
Jan-96 Jan-98 Jan-00 Jan-02 Jan-04
Jan-06 Jan-08
Source: Federal Reserve, Lehman Brothers.

Data: Spread between off-the-run (using Lehman Brothers spline) and on-therun (using the Fed spline) 10-year rates. Date: March 11, 2008
March 17, 2008
SPF 10y Inflation Forecast-10y US

Breakevens, %
Figure 1.
Suggesting TIPS Breakevens May Be

Understating Inflation Expectations
1.6
1.4
y = 4.24x - 0.24
R2 = 0.55
1.2
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
0.00
y = -12.80x 2 + 8.56x - 0.53

R2 = 0.58
0.10
0.20
0.30
0.40
On the Run-Off the Run Spread, %
Source: Philadelphia Federal Reserve website, Lehman Brothers. Date: 10year inflation forecast, 10-year breakevens and liquidity spread. Date: March
11, 2008.
55
The move is quite similar to, although not as large as, the one prompted by the 1998
crisis. Hence, we think it is fair to assume that, in the current crisis, liquidity premium
will also have shifted away from TIPS. So are inflation expectations embedded in 10year breakevens actually higher than outright levels would suggest?
A framework to account
for changing liquidity
in breakevens
The spread between 10-year inflation forecasts (from survey of professional forecasters) and
10-year breakevens has been correlated with the liquidity premium; the higher the liquidity
premium, the lower are breakevens versus inflation forecasts (Figure 2). We note also that
absent a liquidity premium, breakevens would be higher than inflation forecasts (as implied
by the negative intercept on the y-axis), which points to the existence of an inflation risk
premium. Accounting for the liquidity adjustment gives interesting results (Figure 3).
Adjusted breakevens
are a better gauge of inflation
expectations
First, the sharp tightening of breakevens in 1998 was not a reflection of the markets
revising its inflation expectations lower but of the possibility of the relative liquidity of
TIPS drying up. Similarly, even as the average level of breakevens was 1.5% in 20002002, the inflation implied was close to 2.5%, which was more in line with the long-run
average of inflation. From end-2002 to mid-2004, 10-year breakevens widened by 100
bp, which seems surprising given that even as the economy was recovering, there were
still deflation concerns; adjusted breakevens widened by only 50 bp. Currently, the
model suggests that the most recent move wider in breakevens is understating the rise in
inflation expectations, because liquidity premium has increased simultaneously.
Currently, inflation
expectations are higher
than breakevens would suggest
Even though the general conclusion seems right to us, the model may be overstating the
extent of the discrepancy between breakevens and the level of inflation expectations
because the TIPS market has grown considerably over the past decade. The share of
TIPS in Treasuries outstanding has increased from 2%-3% to 10%, and there are more
market participants today. So it would be nave to assume the same sensitivity to
liquidity premium as observed, on average, over the past 10 years. Even if the adjustment
is smaller, it is an addition to already wide levels which has two implications.
First, the Federal Reserve Board should be concerned that its actions are undoing the
work that has gone into anchoring inflation expectations and perhaps consider applying
the brakes to the aggressive easing. Alternatively, investors expecting the aggressive
easing cycle to continue should take note of high inflation expectations and pay close
attention to Fedspeak, which should provide further insights into Fed thinking.
Figure 3.
Adjusted Breakevens: A Better Measure of Inflation Expectations
3.50
3.00
2.50
2.00
1.50
1.00
10y breakevens, %
0.50
0.00
Mar-96
Adjusted 10-yr breakevens, %

Mar-98
Mar-00
Mar-02
Mar-04
Mar-06
Mar-08
Source: Lehman Brothers. Data: adjusted breakeven series using the non-linear estimation. Date: March 11, 2008
March 17, 2008
56
Second, investors in the high-inflation camp should express the view in the front to
intermediate part of the breakeven curve rather than in the 10-year sector, as there
seems to be limited upside in owning 10-year inflation expectations. In addition, we
expect the market to revise its headline inflation expectations by more than it adjusts
its core inflation expectations, which should have a bigger effect further in the curve.
POSITIONING
Level: We like being long 1/09 breakevens because we believe the market is
underestimating headline inflation in 2008 (see the TIPS section in U.S. Rates Strategy
Weekly, March 7, 2008). The main risk to being outright long front-end breakevens is a
sell-off in energy commodities, which, in our view, should be hedged by shorting
gasoline futures (50 contracts of gasoline futures for $100 million of 1/09 TIPS)
Curve: The breakeven curve should be flatter because, given the benign core inflation of
2.1% embedded in 1-year breakevens one year forward, 10-year breakevens at 255 bp look
20 bp too wide (and perhaps wider if we take liquidity into account). If core inflation does
not decline, we expect front-end breakevens to lead the widening, resulting in a flatter curve.
If core inflation does decline in line with the markets expectations, 10-year breakevens
should be 20 bp tighter. Moreover, headline inflation is likely to be higher than the market
expects, which should flatten the curve further. A risk to this trade is a widening of 5y5y
breakevens from a dovish Fed, which we think should be hedged by ED steepeners or credit
spread wideners (see the TIPS section in the U.S. Rate Strategy Weekly, March 7, 2008,
and February 15, 2008). Alternatively, investors can initiate a 2s-5s breakeven flattener
instead of a 2s-10s breakeven curve flattener. The former is less sensitive to the Feds riskmanagement approach.
March 17, 2008
57
Agencies:
Widespread Underperformance
Priya Misra
212-526-6566
prmisra@lehman.com
James Ma
212-526-6566
jamema@lehman.com
Over the past week, agency debt valuations cheapened to historical wides across the
curve against Treasuries and swaps. This was not triggered by any specific GSE credit
headlines. We believe this to be a consequence of general malaise in spread product and
high dealer inventories. We remain comfortable owning 5-years on asset swap and 2years against Treasuries at these levels, consistent with our view of light portfolio
growth/funding needs and reasonable capital cushions.
AGENCY DEBT AT HISTORICAL WIDES VERSUS TREASURIES/SWAPS
Poor performance was led by

the front end, but the asset swap
curve remains steep
Last week was marked by significant agency underperformance across the curve versus
both Treasuries and swaps (Figure 1). Intermediate and long-end spreads are at their
historical wides. The front end sectors underperformed swaps the most on the curve,
which is somewhat reasonable given how well the front end had been trading over the
past several months. Despite the recent move, the asset swap spread curve remains fairly
steep (Figure 2). Thus, we still expect issuance to be concentrated further in the curve.
Last weeks widening did not

appear driven by negative new
information specifically
on GSE credit
The recent underperformance is not based on any specific negative GSE credit news, in
our view. We discussed the 4Q financials in the last weekly publication and both GSEs
have a much healthier capital cushion than they did at the end of 3Q. However, the
economic environment has arguably deteriorated over the past few months amid rising
delinquencies and foreclosures. This likely worsens credit loss projections for the GSEs
over a longer period; however, in the near term lower market prices could create GAAP
losses (derivative losses and mark-to-market losses on the guarantee portfolio). We dont
expect impairments in the subprime/alt-A MBS portfolio, as the credit enhancements
seem to stand up to the GSEs stress tests. However, MTM losses and credit losses
should continue to put pressure on GAAP income for the near term. Thus we expect the
GSEs to remain capital constrained in the near term, which should prevent any pickup in
portfolio growth. Hence we believe debt supply will remain muted in the near term.
Figure 1. Agency Debt Widens to Treasuries and Swaps

bp
bp
120
20
15
10
5
0
-5
-10
-15
-20
-25
-30
100
80
60
40
20
0
1/2/01
1/2/03
1/2/05
1/2/07
5y Agency-Treasury Spread (LHS)

5y Agency Asset Sw ap Spread (RHS)
Source: LehmanLive. 5-year agency option-adjusted spread to Treasuries and
spreads to matched-date swaps. 1/2/2001-3/13/2008.
March 17, 2008
Figure 2. Asset Swap Spread Curve Steepens

bp
10
5
0
-5
-10
-15
-20
-25
0
12
15
18
21
24
27
30
Maturity, years
2/15/2008
7/2/2007
Source: LehmanLive. Spread of par fitted agency curve to par swap curve.
58
Figure 3a. Overall Concerns Increase around Mortgage

and Corporate Credit
bp
7/2/07 12/31/07 2/28/08 3/13/08
Figure 3b. Agencies Post Negative Excess Return

above Treasuries, but Outperform
Other Asset Classes
Excess Return, bp per mo
2007
Jan 2008
Feb 2008
Aggregate
-15
-69
-88
Credit
-32
-151
-99
40
MBS
-13
-14
-76
ABS
-46
-208
-256
CMBS
-31
-440
-523
5y Agency Asset Swap Spread
-18
-21
-2
14
1m FF-Treasury GC
21
41
39
5y Swap Spread
56
73
88
92
CDX IG (5y Senior)
41
77
153
187
Agency
-4
-23
-57
Current-Coupon MBS LOAS
-5
34
53
1-3 Yrs
-1
-13
-11
3-5 Yrs
-5
-22
-52
5-7 Yrs
-6
-34
-101
7-10 Yrs
-6
-36
-108
10-20 Yrs
-7
-3
-77
20+ Yrs
-6
-70
-143
Non-callable
-4
-26
-69
Callable
-4
-16
-27
Bank CDS (5y Senior)
16
57
114
172
Agency CDS (5y Senior)
40
80
78
Agency Equity Price
64
37
26
22
Source: Lehman Brothers
Source: Lehman Brothers Family of Indices
General Spread Product Malaise Affects Agencies

Steady richening of Treasury
collateral has affected a broad
swathe of spread product
Despite the recent lack of supply, agency debt spreads have been widening, which we
attribute to the general spread widening across asset classes and credit concerns
regarding the GSEs. In addition, FHLMC issued $6 billion in debt last week, although
much of this was to offset large redemptions in March and April ($12 billion of maturing
reference notes in total). Figure 3a shows the spread widening across the mortgage and
credit sectors, and the flight-to-quality to Treasury bills has manifested itself in the
richening in Treasury collateral (GC), which widens all spreads to Treasuries. Agency
asset swap valuations held in well until the end of last year; however, continued stress in
spread markets and a rich GC finally seemed to trickle through into agencies. Figure 3b
illustrates the same point by comparing across index returns versus Treasuries. During
2007 as well as the first two months of the year agencies posted negative excess returns,
but outperformed all other spread product. Although we expect the relative
outperformance of agencies to continue, until the credit markets stabilize, it will be
difficult for agency nominal spreads to richen, in our view.
Agency Credit Concerns
GSE-specific credit concerns

amplified in the CDS market
In addition, agency credit concerns have resurfaced, and CDS spreads (which investors
often use as a barometer of credit risk) have widened significantly. We note that the
agency CDS market is not very liquid, so the interpretation of CDS prices may not be
entirely accurate. A news article 1 last week discussed the possibility of a federal bailout
of the GSEs; however, we dont view this to be likely. The GSEs have a substantial
capital surplus versus the Congressional minimum requirement. In addition, the GSEs are
publicly traded companies, with substantial common shareholder equity, making any
attempt at nationalization difficult. However, we would expect both GSEs to attempt to
keep a capital surplus under all circumstances, which may involve letting the portfolio
run off or raising capital. The key issue will be to conserve capital in the near term until
OFHEO lifts the 30% surcharge. We believe some partial lifting is possible once both
GSEs become SEC registrants. We expect this to happen by midyear.
1
March 17, 2008
Is Fannie Mae the Next Government Bailout? Barrons, March 8, 2008.
59
High Dealer Inventories: Fed Action Can Help

Dealer inventories of
agencies have steadily
increased year-to-date
Another factor related to the widening in spreads was the surge in primary dealer
inventories since the beginning of this year (Figure 4). This may appear somewhat
surprising given the lack of net agency supply; however, much of the recent gross
issuance probably was being done on a switch basis, which increases dealer holdings of
bonds. Also, dealers are more likely to own agency debt rather than MBS, given greater
spread realized volatility and potentially higher haircuts in agency MBS. The recent Fed
actions (the $100 billion 28-day term repo and the $200 billion Term Securities Lending
Facility) should help provide financing to dealers against agency debt. However, the
financing is provided against agency MBS as well, which is likely to benefit more given
the greater stress in the passthroughs market. However, given higher dealer inventories in
agency debt, there is still some stabilizing effect from the Feds financing arrangements.
Figure 4.
Surge in Primary Dealer Inventories of Agency Debt

$ bn
Agency Debt
Agency MBS
Corporate & ABS
Jan 2007
61
44
173
July 2007
55
25
225
Jan 2008
69
61
215
March 2008
105
66
183
Source: Federal Reserve H.4.1 Release. Agency debt excludes discount notes. Corporate debt and ABS excludes
issues with less than one year to maturity.
Issuer Diversification: FHLB and FFCB Outperform FNMA/FHLMC

An issuer basis re-emerges,
favoring FHLB and FFCB
For the first time in many years, investors are beginning to differentiate across issuers.
Given the nature of the current crises, the housing finance GSEs have been
underperforming other agency issues. This trend is likely to continue in the near term,
until it is clear that the housing GSEs have accounted for all expected loses. Even among
the housing GSEs, Home Loan credit is arguably better compared with Fannie Mae
(FNMA) or Freddie Mac (FHLMC) because the FHLB doesnt directly guarantee
mortgages but only lends on an overcollateralized basis. Among the more frequent nonhousing issuers, FHLB and Federal Farm Credit (FFCB) have been outperforming
FNMA and FHLMC. The issuer basis is about 5 bp in the front end and increases with
maturity. Note that liquidity in FHLB, and more often FFCB, is not very high, making it
difficult to source much secondary supply. However, we would expect the issuer basis to
persist, and even intensify in the near term.
NEGATIVE NET ISSUANCE IN FEBRUARY
Net redemptions of short-term

debt dominated the changes in
debt outstanding at FNMA
Gross issuance remained strong in February, particularly at the FHLB. As has been the
case over the past few months, most of the new issuance has been concentrated in shortterm debt. However, net issuance has remained roughly flat at FHLMC, FHLB, and was
strongly negative at FNMA (-$25 billion) over the month (Figure 5). The net
redemptions at FNMA somewhat offset heavy net supply in December, as we expected;
this activity was predominantly in short-term debt ($19 net redemptions in February
versus $23 billion net issuance in January).
The GSEs continue to issue

bullets to replace called or
maturing callables
Februarys results were generally a continuation of the trend seen in January and late
2007, of replacing called or maturing callables with net bullet issuancethis was
particularly true at FHLB, where the shift in issuance activity has been roughly
$25 billion per month. Generally at FNMA, the net redemptions in February were
concentrated in short-term debt and callables. FHLMC has deviated from its recent
March 17, 2008
60
Figure 5. Net Issuance Declines in February

as FNMA, FHLMC Increase Caution
around Portfolio Growth
2007 $ bn/mo
FNMA
FHLMC
FHLB
Figure 6. OFHEO Confirms Both GSEs

Are Adequately Capitalized as of 4Q07
Total
$ billion as of December 31, 2007
Fannie Mae
Freddie Mac
Minimum Capital
Statutory Requirement
31.9
26.5
41.5
34.4
Short-term
20
29
Bullet
11
Callable
-5
-4
-8
-16
Minimum Capital
OFHEO Directed Requirement
Total
-1
21
23
Core Capital
45.4
37.9
FNMA
FHLMC
FHLB
Total
-19
-1
-2
-22
Surplus (based on
OFHEO Directed Requirement)
3.9
3.5
Bullet
-8
26
19
Surplus as a % of
OFHEO Directed Requirement
9.3%
10.0%
Callable
-7
-24
-23
Total
-25
-1
-26
Sub-debt Surplus
10.3
6.6
Feb $ bn
Short-term
Source: Fannie Mae, Freddie Mac, FHLB Office of Finance, Bloomberg,

Lehman Brothers estimates
Source: Office of Federal Housing Enterprise Oversight press release,

OFHEO Announces Fourth Quarter 2007 Minimum and Risk-Based Capital
Classification for Fannie Mae and Freddie Mac, March 11, 2008.
pattern in February, offsetting $8 billion of callable net issuance with $8 billion of bullet
net redemptions. Overall, Februarys negative net issuance is not surprising given our
expectations of light portfolio growth.
OFHEO CLASSIFIES BOTH GSES AS ADEQUATELY CAPITALIZED IN 4Q
Official release of the 4Q07
capital classifications shows
both FNMA, FHLMC
adequately capitalized
As detailed in the 4Q07 financial filings, the GSEs increased their capital cushions to
$3.9 billion at FNMA and $3.5 billion at FHLMC as of December 31, 2007 (note that
because of accounting policy changes, FHLMCs cushion was $4.5 billion as of January
1, 2008). The capital shoring actions taken by both GSEs were the largest contributing
factor in the increase of the cushions, which reached the highest levels (as a percentage
of the OFHEO requirements) since 2006 (Figure 6). At the same time, FNMA and
FHLMCs funding needs in the quarter were low: FHLMC grew its portfolio by $8
billion, while FNMA kept its flat. Therefore, the capital required to be held against the
retained portfolios did not increase substantially. Finally, the GSEs sub-debt cushions
were also high as of December 31, 2007.
POSITIONING: OWN 2S VERSUS TREASURIES, 5S VERSUS SWAPS
Remain long 2-years against

Treasuries to benefit from Fed
actions and long 5-years on
asset swap as capital
constraints continue
March 17, 2008
Concerns about L-FF should not affect agency nominal spreads as much as they have
swap spreads, and we expect Treasury GC to cheapen with increasing bill supply and the
Fed actions surrounding the TAF and TSLF. We continue to expect 2-year agencies to
outperform Treasuries. In addition, we believe that 5-year agency asset swap valuations
will richen with the lack of supply, particularly in the context of the recent earnings
releases. We believe that the GSEs will remain cautious regarding their capital cushions,
and as long as the OFHEO 30% surcharge is in place, minimum capital will continue to
be the binding constraint on retained portfolio growth. This will mean that funding needs
should be light, helping asset swap valuations.
61
European Interest Rates Strategy

Its Always Fair Weather
Christophe Duval-Kieffer
44-207-102-7868
cduvalki@lehman.com
Owen Job
44-207-103-4849
owen.job@lehman.com
It is becoming increasingly difficult to balance the difficulties of the global financial

sector with the positive surprises on activity in the euro area. But the risks associated
with financial crisis now clearly outweigh concerns relating to higher inflation, in our
view. The ECB expressed some reluctance to take financial distress into account during
its last press conference, but it might be forced to become more realistic. We increase our
steepening risk further this week on 2s-5s 2-year forward and on real steepeners.
NEUTRAL ON DURATION, EVEN MORE INTO STEEPENERS
From slightly short to

neutral on duration
The duration scorecardLehman Brothers quantitative metric for durationremains

in short territory but is now very close to neutral, as is our stance on duration.
Signs of financial distress have once gain accumulated over the week, with increased
signs of distress on short-term funding markets. With the collapse of a major U.S.
investment bank, the crisis reaches a new stage. Last week, we increased our
exposure to steepeners, taking advantage of the flattening move that followed the
ECB press conference. This week we increase it further.
Confronted with major financing difficulties at a major U.S. investment bank, the
markets stance has shifted. True, the release of the HICP numbers showed inflation at a
14-year highalthough the jump from 3.2 to 3.3% was the result of a very small upward
surprise and the effect of rounding. But the bond market dismissed the surprise on
inflation and focused on the fact that the financial crisis is reaching a new stage.
Indeed, while segments of the market had individually but consecutively collapsed in the
previous stages, they have now simultaneously collapsed: equity markets are down,
credit markets are still reflecting historically high spreads and short-term funding
markets are experiencing severe tension, with euribor and libor spreads to the overnightindexed swap rate getting closer to July levels. Also, sovereign spreads in the euro area
Figure 1. A Sharp Widening in Euribor/OIS Spreads

5.5
5
4.5
100
120
80
100
60
40
3.5
20
2.5
2
04/01/2002
04/01/2004
3-month euribor
04/01/2006
Figure 2. Also in the U.S.
-20
04/01/2008
March 17, 2008
60
40
20
1
0
04/01/2002
04/01/2004
04/01/2006
0
04/01/2008
3-month euribor
3-month OIS
US Libor/OIS spread
3-month OIS
Euribor/OIS spread
Source: Bloomberg
80
Source: Bloomberg
62
are at historical highs against Germanynot only the usual non-triple A suspects; nonGerman triple A have also shown no sign of recovery. Needless to say, auctions
scheduled by some European Treasuries during the week did not go smoothly, with signs
of weak demand for cash linked to constraints on balance sheets in the banking sector.
Finally, swap spreads are reaching historical highs.
The balance of factors changes
The press conference that followed the no-change decision by the ECB last week showed
a slightly hawkish ECB taking comfort from the resilience of euro activity numbers and
high inflation. Indeed, the HICP for February surprisedagainon the upside. In its
perception, risks stemming from the financial sector did not seem enough to change its
stance. The most recent events might have changed this view.
By contrast with the activism of the Federal Reserve on interest rates and its ability to
create new policy tools specifically adapted to the crisis (e.g., the security-lending
facility), the ECB has been less responsive to the financial crisis and less innovative. It is
true that it supplied liquidity with no limit on volume in December 2007 but generally it
has chosen to make full use of its existing arsenalarguing, for instance, that its
collateral regime is already very broad, rather than broadening it.
So, the ECB finds itself unwilling to extend its arsenal on liquidity and direct market
intervention and at the same time committed to an increasingly short-term view of
inflation, based mostly on exogenous pricesenergy and foodwhich it cannot control.
The main direct upside of this strategy is that the strong euro is limiting the impact of
higher oil prices; oil prices in euros are up 43% year-on-year, against 66% in dollars.
Had the Eurodollar exchange rate remained constant, inflation could now be 3.7/3.8%
instead of 3.3%. Another potential upside is that wage bargaining rounds are taking place
in a rather tense contextthe threat of higher inflation being emphasised so much that
even German trade unions cannot ignore it.
Against this backdrop, the market is asking for no extra inflation premium on long-dated
inflation forwards; the 5y5y forward inflation rate remains under control and the inflation
curve is flattening. It is hard to say whether the absence of meaningful extra inflation
premium being priced in is the outcome of the tougher monetary stance. As we underlined
in European Inflation Strategy, March 12, the relationship between the slope of the
euribor curve and the forward inflation swap rate is ambiguous. In our view, a more
accommodative stance would not necessarily result in a much higher 5y5y inflation rate.
Figure 3.
Inflation Surprises Upward
0.5 cumulated surprises

0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
-0.4
-0.5
Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08
Euro-area flash HICP
March 17, 2008
Figure 4.
and Banks Surprise Downward
Z-score
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08
US bank CDS
EUR bank CDS
Source: Bloomberg
63
Figure 5.
No Credibility Cost Associating with Changing the Stance
3.5
100
3.3
90
3.1
80
2.9
70
2.7
60
2.5
50
2.3
40
2.1
30
1.9
5y5y euro
1.7
1.5
Jan-05
Jul-05
Jan-06
5y5y US
Jan-07
Jul-06
20
Differential
10
Jan-08
Jul-07
Source: LehmanLive
Positioning further
for steepeners
As a result, we believe that the market will price with a higher probability a scenario of a
late-starting ECB, with downward pressure on the M9-M0 portion of the strip. We see this
as a motivation to increase our risk on steepeners in different formats. We are currently
running the following steepening trades, trying to benefit from our macro scenario with
limited exposure to further increases in euribor fixings (forward steepeners) or trying to
make full use of the strong positive inflation carry in April (real steepeners).
Figure 6.
Our Preferred Steepeners

Trade
Levels, 13/03
(bp)
2m Fwd
2s5s 2y Fwd
24
25
Buy BTANei 201, Sell OATei 2015
14
18
"With Exposure to Country Spreads" Buy BTPEI 2012, Sell DBRI 2016
-10
23
Format
Forward Steepeners on Swaps
Real Steepeners
"Carry-protected"
Figure 7.
Euribor Strip Adjusted from OIS Spreads Shows

that a Late-Starting ECB Is Starting to be Priced in
4.5
4.25
27-Dec-07
10-Jan-08
05-Feb-08
26-Feb-08
04-Mar-08
14-Mar-08
4
3.75
3.5
3.25
3
2.75
Spot
H8
M8
U8
Z8
H9
M9
U9
Z9
H0
M0
U0
Source: Bloomberg
March 17, 2008
64
A pure euribor strip trade
Also, to provide medium-term exposure to an outperformance of euribor, we choose to

pay some premium and add call spread on euribor. This should allow us to hold the trade
for the medium term with limited downside exposure if the ECBs hawkish rhetoric is
maintained in the short-term while inflation threats remain high. We choose to position
in ERU9, where the terminal rate for the ECB is currently expected. Buying midcurve
options on these futures means we can hold options that expire in six months into futures
that expire in 18 months.
We recommend buying a 96.75/97.00 call spread for 8 ticks. This provides a 2:1 risk
reward for the market pricing in ECB repo rates lower than 2.60% (assuming a
pessimistic Libor-OIS spread of 40 bp) by September 2009. The breakeven for the trade
is the ERU9 contract pricing in 3.17 bp for three-month euribor at expiry of the option,
September 15, 2008. We expect much of the inflationary concern to have passed by
September; we forecast euro area inflation to peak in March and HICPxT to have
receded to 2.4% by September 2008. Hence, by September of this year we believe the
ECB will have been freed from inflationary concerns and that positive data surprises
from the euro-area growth data will have long since passed. This should lead the way for
the market to price in a more aggressive easing cycle from the ECB.
March 17, 2008
65
Euro Relative Value:

U.K. Swap Spreads: Wild Thing
Medha Khanna
44-207-102-7594
medha.khanna@lehman.com
The recent widening in short term sterling swap spreads seems unjustified, especially
relative to euro area swap spreads. However, the increase in directionality of U.K. swap
spreads with the two-year benchmark yield suggests that we should wait for the extreme
volatility in the markets to ease before initiating the trade.
NO END IN SIGHT
In the past week, sterling swaps have blown up, without substantial justification, in our
view. We examine the movement in swap spreads and conclude that their directionality
with the 2-year benchmark yield has been the driving force in this move. Although we
consider these spreads to be wider then their fair value, we hesitate to add a short swap
spread trade in the immediate term. Severe risk aversion in the market has led to an
increase in demand for short term Gilt paper, which could exacerbate the situation in the
short term before the descent to fair value begins.
Follow the Leader
On regressing two year U.K. swap spreads against the two-year benchmark yields since the
beginning of 2000 we find a co-efficient of 6.14 and an R-squared of 0.076, indicating a
poor fit between the two. However, on running the same regression since the beginning of
2007, the R-squared increased to 0.51 indicating that the directionality between the two
year benchmark yields and two year swap spreads has increased. It is this correlation that
we judge has been driving the market in the past few weeks; taking the 2-year spreads to
unprecedented highs. As Figure 1 illustrates, since February 29, two-year benchmark yields
have rallied by 20 bp while two-year swap rates have sold off by 20 bp. This 40 bp
widening in sterling swap spreads is particularly interesting if we compare it to euro twoyear swap spreads which have widened by only 4 bp. This has led to the two-year euro and
sterling swap spread differential to reach an extraordinary high of 55 bp.
We examine further the relationship between short-term euro area and sterling swap
spreads. Although the correlation between the two is low (R-squared of 3% since the
beginning of 2000 and 8% since the beginning of 2007), they do share directionality
(Figure 2). Furthermore, there is a 67% correlation between the change in two year euro
and sterling benchmark yields (Figure 3). This makes the diversion in their direction
even more unusual. Other studies conducted on sterling and euro swap spreads have also
concluded that while there is no volatility transmission from the euro swap spreads to the
sterling swap spreads, their directionality is related. Running a Granger causality test on
euro and sterling swap rates shows that short-term euro swap spreads Granger-cause
Figure 1.
Two-year Euro Area and Sterling Swap Rate and Benchmark Yields
UK
Euro Area
2 yr Swap Rate
(%)
2 yr Benchmark
Yield (%)
2 yr Swap Rate
(%)
2 yr Benchmark
Yields (%)
March 14, 2008
5.074
3.870
4.074
3.363
February 29, 2008
4.881
4.069
3.823
3.160
Change (bp)
19.3
-19.9
24.65
20.3
Source: Bloomberg
March 17, 2008
66
Figure 2.
Two-year Sterling and Euro Swap Spreads
Figure 3.
140
120
100
80
60
40
20
0
Mar-00
Mar-02
Mar-04
Mar-06
Mar-08
0
Mar-00
Two-year Sterling and Euro Benchmark Yields
Mar-02
Mar-04
Mar-06
2 yr sterling sw ap spreads
2 yr sterling benchmark yield
2 yr euro sw ap spreads
2 yr euro benchmark yield
Source: Bloomberg
Mar-08
Source: Bloomberg
short term sterling swap spreads. 2 This leads us to conclude that while a widening in
sterling swap spreads is not unwarranted (given the increase in risk aversion and the
widening of euro swap spreads), the recent spike is overdone.
Swap Rate not Justified
Having accounted for the benchmark yield, we now consider the swap rate to analyze
whether the sharp rise of 19 bp since the end of February is justified.
We take the one-year swap rate and deduct from it the average of the forward 3-month
Libor-OIS spread for the next year4.75%. We compare this rate with the Libor rate
priced in by the L H9 contract minus the 3-month Libor-OIS spread nine months
forward3.92%. The 83 bp difference between the two is the additional cost of longerterm borrowing. The same analysis performed on the one-year euro swap rate reveals a
spread of 75 bp. We do not believe there should be an excess cost of borrowing in the
euro area compared to the U.K. and thus deem the U.K. spreads to be 8 bp too wide. This
is further supported by the spread between the 1-year swap rate and 1-year swap rate one
year forward in U.K., which is 88 bp, versus 69 bp in the euro area.
A Question of Trust
Our analysis concludes that 2-year swap spreads are overvalued and should correct, but we
hesitate to initiate this trade given recent extreme volatility. While the Libor-OIS spreads in
the euro area have become less skewed, those in U.K. continue to show a spike in the 1-2
month period, suggesting there is still much apprehension about liquidity in the short term
(Figure 4). Thus, we will wait for the current volatility to subside before initiating the trade.
March 17, 2008
1 An investigation into the linkages between euro and sterling swap spreads by Somnath Chatterjee
67
Figure 4.
Libor-OIS Spreads for Euro Area and U.K.
120
EUR
GBP
100
80
60
40
20
0
0d
1m
2m
3m
4m
5m
6m
7m
8m
9m
Source: LehmanLive
March 17, 2008
68
Sterling Strategy:
Surprising Resilience
Owen Job
44-207-103-4849
ojob@lehman.com
Giada Giani
44-207-102-1135
giada.giani@lehman.com
We consider the continuing deteriorating global growth outlook a greater negative for the
U.K. economy than for the euro area, where recent data have consistently surprised to the
upside. The U.K.s dependence on financial services for growth, its higher use of
leverage, lack of fiscal support and slowing housing market all lead us to expect a
reversal in trend and to position for sterling outperformance versus euro. We receive 10year GBP swaps versus EUR.
IN THE FACE OF DETERIORATING GROWTH PROSPECTS
Medha Khanna
44-207-102-7594
medha.khanna@lehman.com
Negative housing data
Figure 1.
The macroeconomic picture is not improving in the U.K. relative to the euro area. The
latest house price data, a critical metric for the U.K. economy, continue to deteriorate.
The data of the past two months out of the U.K. has been much as expected, whereas data
from the euro area have consistently surprised to the upside. The poor performance of the
financial sector will likely weigh heavily on the U.K. economy, which has a sizable
proportion of its GDP attributable to the financial industry. Despite this, the spread
between 10-year swap yields in euro and sterling has been relatively range bound for the
past month after a strong underperformance of sterling at the beginning of the year. We
expect this trend to reverse and add a cross-currency trade, buying sterling 10-year swap
rates versus euro.
The latest data for the U.K. have not been positive. The RICS sales-to-stock ratio,
which we regard as a good leading indicator for U.K. house prices, is now indicating
a fall in nominal house prices (Figure 1). The last time this occurred was in the early
1990s, when interest rates were subsequently cut by 975 bp. This is clearly a scenario
and such easing is now impossible, but the leverage of the U.K. consumer and its
dependence on housing strength is clear. Declining house prices provide a very
negative outlook for the U.K. economy.
House Prices and Sales-to-stock Ratio
Figure 2. Lehman Data-Surprise Indices for Euro

and Sterling Show Recent Relative Positive
Surprises for Euro
surprise index
0.6
Sterling surprise index

Euro surprise index
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
Jun-07
Source: RICS, HBOS, Nationwide, Lehman Brothers Global Economics
March 17, 2008
Aug-07
Oct-07
Dec-07
Feb-08
Source: Lehman Brothers, Bloomberg
69
Euro data surprisingly

buoyant, not so the U.K.
We extend our data surprise index to the U.K. data. This reveals that unlike in the euro
area, which has experienced consistent upside surprises over the past two months, the
U.K. data have been very consensus (Figure 2). Much of the upside data in the euro area
has come out of the surprisingly robust Germany. We expect this to turn in time, but only
once slowing global exports feed though into the economic data.
Lack of fiscal support and

financial sector weakness are
further negatives for U.K.
The U.K. economy, on the other hand, differs structurally from the German. It is much
more exposed to the tightening of lending standards through greater reliance on
consumer credit and higher corporate borrowing. And, crucially, the U.K. economy has
become increasingly dependant upon the financial services for growth in recent years. As
financial services struggle in the post-credit crunch environment, as looks probable, U.K.
growth will likely be negatively affected. U.K. Chancellor of the Exchequer Alistair
Darling failed to help matters this week, announcing a net increase in the consumers tax
burden in the annual budget. The delay of an increase in road fuel duty to October is
unlikely to soften the blow of a net tax increase of 2.5 billion over three years. This is a
long way from the fiscal support being offered to combat slowing growth prospects in
the U.S. Despite these reasons for a relatively dovish outlook on the U.K. versus euro,
U.K. swaps have underperformed euro since the beginning of 2008 (Figure 4).
Additional Gilt issuance makes

longs more attractive in swaps
The recent DMO remit, announced this week, is likely to have a negative impact on Gilts
versus swaps because it appears that the loan to Northern Rock is to be funded almost
entirely via greater Gilt issuance; the DMOs plan for the next year is to auction more
than 80 billion of Gilts, the consensus expectation was closer to 60 billion. This leads
us to prefer holding a long position in sterling swaps rather than Gilts, which we believe
are likely to underperform as the issuance plan is digested.
Trade Recommendation
Rec 10y GBP swaps @ 5.03%
Pay 10y EUR swaps @ 4.35%
=> EUR-GBP spread tightener @ 68 bp
Figure 3. Gilt Issuance
Figure 4. EUR-GBP 10y Spread in Swaps Has Retraced

from Lows Earlier in the Year
mm
90,000
DMO forecast
80,000
bp
120
100
70,000
80
60,000
50,000
60
40,000
40
30,000
20,000
20
10,000
EUR-GBP 10y spread
0
1999
Source: DMO
March 17, 2008
2001
2003
2005
2007
0
Mar-07 May-07
Jul-07
Sep-07 Nov-07 Jan-08 Mar-08
Source: Bloomberg
70
Euro Area Inflation Strategy:

Youve Got to Believe
Christophe Duval-Kieffer
44-207-102-7868
cduvalki@lehman.com
With a weaker than expected French CPI and a stronger HICP, EUR/FRF inflation spread
should perform. Our forecast revision has quite a strong impact on the April inflation
carry, so we remain long euro versus French inflation in the short run. We also examine
the widening differential between U.S. and euro inflation forwards and reassess the
ECBs credibility as an inflation fighter. We still like inflation flatteners and do not
expect a re-building of the inflation premium.
WIDER EUR/FRF SPREADS
Weaker-than-expected French
CPI adds fuel to the long
euro versus French trade
French consumer price inflation was tamer than generally expected in February. French
CPI rose by 0.2% month-over-month (nsa), versus a consensus of 0.4% (Lehman: 0.3%).
In annual terms, inflation remained stable at its highest level since May 1992, at 2.8%.
The harmonized inflation ratewhich feeds into the euro-area aggregatewas also
stable, at 3.2%. The FRCPIxT index printed at 116.57, versus our expectation of 116.68.
Our economist, Giada Giani, has revised her forecast on French inflation to the
downside. Both the 2-year and the 5-year swap rate differentials widened on the back of
the release, as did the OATei 2012/OATi 2013 breakeven spread.
The carry on FRCPI-indexed bonds has changed; on the OATi 2009 it is now -11 bp for a 1month horizon, from -7 bp in our previous forecast. Further out, the magnitude of the impact of
the forecast change on carry is also significant and hurts the inflation carry on French inflation.
Yet the main revision in the forecasting profile negatively affects the inflation carry in April.
Figure 1.
French Inflation Forecasts
FR CPIxT Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08
Old
Forecast
116.32 116.68 117.30 117.51 117.69 117.74 117.41 117.57 117.74 117.76
New
Forecast
116.32 116.57 117.23 117.43
117.6
117.65 117.32 117.48 117.65 117.67
Figure 2.
Old Inflation Carry on French Inflation-linked Bonds

Spot
Issue
Nominal Comp Breakeven
Breakeven Carry (bp)

1mth
2mth
3mth
6mth
FR CPIxT
3.00% Jul-09 OATi
4.00% Apr-09 OAT
2.330%
-7.1
14.8
33.8
36.3
1.60% Jul-11 OATi
6.50% Apr-11 OAT
2.261%
-2.6
5.9
12.6
13.2
2.50% Jul-13 OATi
4.00% Apr-13 OAT
2.248%
-1.8
3.4
7.4
7.4
Figure 3.
New Inflation Carry on French Inflation-linked Bonds

Spot
Issue
Nominal Comp Breakeven
Breakeven carry (bp)

1mth
2mth
3mth
6mth
FR CPIxT
3.00% Jul-09 OATi
4.00% Apr-09 OAT
2.330%
-11.2
8.1
27.7
28.9
1.60% Jul-11 OATi
6.50% Apr-11 OAT
2.261%
-4.2
3.4
10.5
10.7
2.50% Jul-13 OATi
4.00% Apr-13 OAT
2.248%
-2.8
1.9
6.0
5.9
March 17, 2008
71
Figure 4.
Monthly Carry on 10-year IL Bonds Indexed to French Inflation

Ex-Tobacco, bp/month
0.20
0.15
0.10
0.05
0.00
-0.05
-0.10
-0.15
Mar-08
Apr-08
May-08
French old forecast
Jun-08
Jul-08
Aug-08
French new forecast
Source: Lehman Brothers.
Meanwhile, the euro HICP has surprised on the upside, and our economist has revised
upward our HICP inflation forecasts.
The inflation carry on 10-year bonds indexed to the euro HICP excluding tobacco is
therefore slightly better.
We take this change as vindication of our long EUR/short FRF stance
Figure 5.
HICP Inflation Forecasts
HICPxT
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
OLD
105.67
106.01
106.80
107.12
107.32
107.29
yoy
NEW
3.21
3.22
3.29
2.95
2.89
2.76
105.67
106.04
106.87
107.29
107.56
107.53
3.21
3.25
3.37
3.11
3.12
2.99
yoy
Figure 6.
Monthly Carry on 10-year IL Bonds Indexed to Euro HICP Inflation

Ex- Tobacco, bp/month
0.30
0.20
0.10
0.00
-0.10
-0.20
-0.30
Mar-08
Apr-08
May-08
Euro old forecast
Jun-08
Jul-08
Aug-08
Euro new forecast
March 17, 2008
72
THE GREAT DIVIDE: U.S. VERSUS EURO ANTI-INFLATION CREDIBILITY

A look at inflation-fighting
credibility: Fed versus ECB
In recent weeks, the 5-year inflation rate, five years forward, differential between the U.S.
and the euro area has widened sharplyfrom around 40 bp in January to more than 80 bp.
The inflation market has been quick to re-price long-dated inflation upwards in the U.S.,
which has been seen as the expression of some doubt on the inflation-fighting credentials of
the Federal Reserve. As usual, most of the price action on the spread is the result of the repricing of U.S. inflation. However, the spread is now near the peaks of 2006 and 2004.
Meanwhile, the U.S. inflation curve as measured by the 5y, 5y5y spread has marginally
steepened while the euro inflation curve has flattened. This would suggest that the longrun target for inflation in the U.S. is being revised upward, while the tougher inflationfighting stance of the ECB has paid off in terms of containing the expected level of
inflation in the long runeven reducing the inflation curve. In other words, semiexplicit inflation targeting in the euro area has succeeded in containing any widening of
the inflation premium while the Federal Reserves risk management stance has fuelled
upward pressure on long-dated inflation.
But such an interpretation ought to be taken with a pinch of salt. The first reason is that,
since the start of the year, the inflation curve in the U.S. has been lower, not higher, which
does not really suggest huge concern about the Feds anti-inflation credentials. The second
reason is ECBs tight stance, which seems to have resulted in falling inflation forwards.
We think the move in 5y5y forward inflation rates in the euro area has been too recent to
reflect the impact of a tougher stance and it is a well-known feature of the euro inflation
swap market that longer-dated forwards are not very volatile. Most of the re-pricing in
terms of monetary policy expectations in the euro area has taken place since the
beginning of January, from a flat (OIS-adjusted) euribor strip to a sharply inverted one.
The 5y5y inflation rate is now 2.43%unchanged from December 28!
This simple metricrevision in the slope of the euribor curve vs 5y5y inflationdoes not
show a statistically significant correlation at presenttypical if the central bank is perceived
as crediblealthough there may be an emerging trend towards a more inverted H8H9 curve
correlating with higher 5y5y inflation. We do not find the evidence compelling enough at this
stage to expect a wider inflation premium, but investors concerned about ECB credibility can
be long the 5y5y inflation swap ratereceive floating inflation 5-year forwards. Needless to
say, this trade is consistent with a view of a more inverted euribor strip.
Figure 7. A Wider 5y5y US/EUR Inflation Differential
Figure 8. A Slightly Steeper Inflation Curve in the U.S.
120
70
3.5
100
60
80
50
60
40
40
30
20
20
10
3
2.5
2
M
ar
-0
Se 3
p0
M 3
ar
-0
Se 4
p0
M 4
ar
-0
Se 5
p0
M 5
ar
-0
Se 6
p06
M
ar
-0
Se 7
p07
1.5
5y5y euro
Source: LehmanLive
March 17, 2008
5y5y US
Differential
0
12/03/07
12/06/07
12/09/07
5y5y 5y spread US
12/12/07
5y5y 5y spread eur
Source: LehmanLive
73
Figure 9.
An Emerging Trend, Although Not Very Significant
2.48%
5y5y fwd inflation
2.46%
2.44%
2.42%
2.40%
2.38%
2.36%
-120
-100
-80
-60
-40
-20
20
H8-H9 contract re-pricing since Decem ber 07

Source: LehmanLive, Bloomberg
March 17, 2008
74
Asian Interest Rates Strategy

Rally Causes Several Distortions
Makoto Yamashita
81-3-6440-1411
makyamas@lehman.com
We maintain our long duration/steepening bias, but the current rally has caused several
distortions in the JGB curve. We recommend the 5-7-9 short butterfly to capture the
richness of the 7-year sector. In addition, we expect the BEIs of several issues to return to
positive territory because of a possible increase in domestic investor demand in April.
ALTHOUGH 7-YEAR JGBS LOOK TOO RICH
On the back of sharp dollar depreciation and concerns about the U.S. economy, the 10year JGB yield dropped below 1.3%, the lowest level since July 2005, accompanied by
several distortions in the JGB curve.
First, comparing the JGB forward curve with the swaps curve, 7-year JGBs (yen bond
futures) appear extremely rich, while super-long bonds look cheap (Figure 1). Should
investors use JGB 7s-20s flatteners or short 7-year swap spreads to capture the richness
of the 7-years? We dont think so, as the risks of these trades appear more or less
equivalent to being short duration, as shown in Figure 2. In fact, 7-year JGBs still appear
rich on a residual basis, adjusted with a single-regression analysis of 7-year JGB yields;
however, this richness is not unreasonable considering the possibility of a rally, with
sharp yen appreciation and a widening of GC-Libor spread in the short end.
Therefore, we recommend a JGB 5-7-9 short butterfly. The 5-7-9 short butterfly also has
a good correlation with short 7-year JGBs, as shown in Figure 2; however, the 5-7-9
short fly looks too cheap based on previous 5-year data. In other words, if yen rates
markets continue to rally to imply a possible rate cut or QE, the 5-year sector could
outperform along with the 7-year (Figure 3).
Figure 1.
Forward JGB and Swaps Curves
Figure 2.
bp
4.0
60
40
-5
3.5
bp
bp
20
2.5
-20
2.0
-20
-25
110
1.0
JGB fw , LHS
-60
-40
-80
-45
0.85
7yYYS, LHS
5-7-9 JGB FLY, LHS
7-20 JGB SP, RHS
-35
Mar
100
90
R2 = 0.54
-30
-40
March 17, 2008
R2 = 0.87
Mar 13th
YYS fw , RHS
SWAP fw , LHS
120
-15
1.5
1 2 3 4 5 6 7 8 9 10 11 12 13 14 1516 17 18 19 20
y
130
R2 = 0.63
Mar 13th
-10
3.0
0.5
7-year JGB Yield versus Swap Spreads,

5-7-9 Butterfly, and 7s-20s Spread
80
70
60
0.95
1.05
1.15
7y JGB Par Rate, %
Source: Lehman Brothers. Data during previous three months.
75
Figure 3.
5-7-9 Butterfly versus 7-year JGB Par Rate
5-7-9FLY, bp
25
Before QE end (03-Mar06)

After QE end (Mar 06)
20
15
10
5
0
-5
-10
-15
-20
0.00
Mar 13th
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
7y JGB Par Rate, %

Second, the breakeven inflation rate (BEI) looks too low, as the BEIs of several issues
turned negative as long positions were unwound. Domestic investors avoided buying
JGBi because of negative BEI carry ahead of the accounting year-end in March;
therefore, BEI is expected to return to positive territory in April.
Third, 15-year JGB floaters have become much cheaper, as the actual increase in price
has been slow compared with the sharp rise in theoretical value as a result of rapid
steepening. 15-year floaters seem to have been sold off not only by overseas investors
but also by domestic investors who cut unrealized losses at accounting year-end. This
could provide an opportunity to take advantage of the cheapness of 15-year floaters, as
the supply/demand balance is expected to improve with the increase in the Ministry of
Finance buyback to 1.2 trillion yen from around 0.5 trillion yen in fiscal 2007.
Figure 4.
BEI of JGBi4 and JGBi14
Figure 5.
0.80
BEI of JGBi4
80
BEI of JGBi14
75
0.40
7
6
65
60
55
0.20
50
45
40
0.00
March 17, 2008
10s-20s JGB Spread, LHS

Implied Alpha, LHS
Cheapness, RHS
70
0.60
JPY
bp
-0.20
07/1
10s-20s JGB Spread, Implied Alpha,

and Cheapness of JGB Floaters
35
07/7
08/1
30
06/1
0
06/4 06/7 06/10 07/1 07/4
07/7 07/10 08/1
76
MBS
Can Someone Hit the Brakes?
MBS Strategy
Vikas Shilpiekandula
212-526-8311
vshilpie@lehman.com
Agency MBS
Prasanth Subramanian
psubrama@lehman.com
Olga Gorodetsky
ogorodet@lehman.com
Residential Credit
Akhil Mago
akmago@lehman.com
Rahul Sabarwal
rsabarwa@lehman.com
Madhuri Iyer
madiyer@lehman.com
The week started off with an overhang of pressures from potential MBS sales by
leveraged entities. On Tuesday, the Fed announced an extension of $200 billion under
the TSLF program against agency pools and private label AAAs, partly alleviating
concerns about such risks. Current coupon TBAs tightened by about 15 bp, to L+48 bp,
on the heels of this announcement. On Friday, the sell-off in spread sectors created by
the Bear Stearns news pushed mortgages back to all-time wides.
STAY NEUTRAL TO THE MORTGAGE BASIS
The turmoil in the markets justifies our move to a neutral position on the mortgage basis
last week. While the Feds recent announcement alleviates concerns about financing,
there is still a substantial supply/demand imbalance in agency mortgages. We expect
more than $50 billion in monthly net supply of agency mortgages even after accounting
for the recent widening in spreads. This cannot be absorbed by traditional sources of
demand for the sectorbanks and the GSEsgiven their balance sheet and capital
constraints, and money managers should find other assets, such as AAAs, more
attractive than agency MBS. That said, there is significant event risk in a short basis
position. In light of this, we continue to recommend a neutral allocation to the basis. We
have more conviction in up-in-coupon and IO exposure, where pricing still doesnt
reflect the rather slow prepay environment.
ADD EXPOSURE TO SUPER SENIOR AAAS WITH NO LEVERAGE
Consumer ABS
Brian Zola
bzola@lehman.com
Kumar Velayudham
savelayu@lehman.com
Fundamentally, super senior AAAs in the prime/alt-A sector are the most attractive high
quality assets. It is true that alt-A delinquencies have deteriorated significantly in recent
months, but the pricing of SS AAAs reflects scenarios in which all the remaining
borrowers end up in default with severities greater than 60%. Under our base-case
assumptions, these assets are trading to unleveraged returns of 12%-15%. Obviously,
one cannot understate the importance of technicals in this market, and there is a risk of
further widening due to potential asset sales. At the same time, conditions in the capital
markets have deteriorated so significantly that more aggressive corrective action from
the Fed and the administration seems plausible. Under such a scenario, SS AAAs would
be the biggest beneficiaries. To reflect this view, we are adding exposure to option ARM
SS AAA passthroughs with no leverage in our portfolio.
Figure 1.
Sector
Agency
Prime
Subprime
Indicative Spreads across Sectors

Asset
Today
Last Week
End-2007
Fixed-Rate MBS
53
62
5/1 Hybrid
184
121
55
Jumbo SS
8-00
2-20
2-08
Alt-A SS PT
$75
8-16
3-00
Option ARM SS
$75
$82
200 DM
Cash 1yr AAA
350
363
175
ABX 07-1 AAA
867
884
483
Source: Lehman Brothers. For agency collateral, we show Libor option-adjusted spreads. For jumbo collateral, we
show the price drop to agency. For alt-A and option ARMs, we show the approximate dollar price where such
assets are trading. For subprime and ABX AAAs, we show spread to Libor.
March 17, 2008
77
ABX TOP OF CAPITAL STRUCTURE RALLIES ON HEADLINES

The Feds liquidity infusion
proposal and S&Ps comments
about limited future subprime
losses rallied indices
up the capital structure
Although characterized by the typical volatility associated with the subprime space, the
ABX indices staged a small rally up the capital structure this week, sparked by a
combination of the Feds liquidity infusion proposal and positive comments from S&P
about limited future subprime losses. Overall, AAA/AAs rallied 100-300 bp and the
subordinates sold off by 25-200 bp as the curve steepener trade came into play this week.
The first positive news of the week came on Tuesday, when the Fed announced an
infusion of $200 billion of liquidity into the system by lending Treasuries against
collateral including mortgage-backed securities. ABX AAAs rallied 1-3 points across
vintages following the Fed news, and there was another AAA/AA mini-rally on
Thursday when S&P announced that a majority of subprime-related losses had already
been recognized at banks and other financial institutions. However, the AAA rally halted
on Friday as the AAA ABX indices sold off in line with the broader capital markets.
Congressman Franks Refinancing Plan
Congressman Franks
plan to refinance borrowers
was met with a positive
response by the market
Another notable headline this week was the proposal by Congressman Barney Frank
related to FHAs refinancing of between 1 million and 2 million borrowers. The proposal
stipulates that lenders/investors with exposure to the original mortgage recognize any
losses to the extent of the difference between the updated value of the mortgage and the
original mortgage. Thus, the overall tone was largely positive this week, and the market
even discounted news of the potential liquidation of a mortgage fund run by the Carlyle
Group after significant margin calls.
Loss Expectations Revised Upward
We have revised loss

expectations upward given
worsening performance and
deteriorating market conditions
March 17, 2008
Although market technicals were largely positive this week, on the fundamental side, we
recently revised our loss expectations upward given worsening collateral performance in
the prime space and continued worsening in housing expectations (click here for more
details). However, even with updated loss expectations and the AAA/AA mini-rally this
week, we like the ABX indices up the capital structure and recommend the following
trades: long ABX 06-2 AAs versus ABX 06-1 BBBs/CDX.HY100.9; long ABX 07-1
AAs versus 07-1 BBBs; and long ABX 07-2 AAs versus ABX 07-2 BBBs.
78
Mortgage Leveraged Portfolio

HEADLINES DRIVE PORTFOLIO PERFORMANCE ON THE WEEK
Much of the outperformance of the convexity portfolio came last Thursday when the
mortgage basis sold off sharply. As a result, our short FN 5s versus swaps position
generated 76 bp of return on the day. With volatility high and spreads at their widest
levels in history, we turned neutral on the basis. Please see our publication Turning
Neutral on the Basis for a more in-depth look at the decision, as well as changes to our
trades. Our GN/FN 6.5 position suffered following Congressman Barney Franks
proposed plan to stem foreclosures by expanding the FHA program.
The combination of Feds liquidity infusion proposal and positive commentary from
S&P around limited future subprime losses caused a midweek mini-rally in the ABX.
The market cooled off on Friday though, in line with the broader capital markets. On the
credit leveraged portfolio, all our ABX trades moved in our favor with the top of the
capital structure holding up, while the BBBs/BBBs remaining flat to slightly negative.
However, accounting for the bid-offer spread on our new credit trades, we end this week
with a -0.9% RoE. We are adding a cash position in super senior AAA option ARM
passthroughs. For a full discussion of this trade, please see this weeks Overview.
New Trades
Credit Portfolio
1.
Long Super Senior AAA Option ARM Passthrough Bonds: Fundamentally,

super senior AAAs in the option ARM sector are the most attractive high quality
assets, in our view. Under our base-case assumptions, these assets are trading to
unlevered returns of 12%-15%. In the event of a Fed action, super senior AAAs
would be the first to benefit.
Open Trades
Convexity Portfolio
1.
Long GN/FN 6.5 swap: We believe the GN/FN swap is undervalued because of
supply, prepayment, and buyout concerns.
2.
Long FHT 245 IOs versus Current Coupons: The market is ignoring the potential
for slow turnover in a weak housing market. We are hedging the IOs with current
coupon mortgages instead of swaps to eliminate exposure to the basis.
3.
Long 6.5s versus 5.0s: We expect prepays to decline across the board because of
negative HPA and tighter credit. We favor 6.5s because they are more like alt-As in
terms of their collateral quality.
4.
Long DW 5.5/FN 6 Swap: We think the sector has not kept pace with recent curve
steepening and increases in volatility. The sector should also benefit from weak
supply and turnover dynamics.
Credit Portfolio
5.
March 17, 2008
Long ABX 06-2 AAAs versus ABX 06-1 BBBs/CDX.HY.100.9: Yields on the 062 AAAs are attractive versus ABX 06-1 BBBs. The CDX.HY.100.9 is a hedge again
an overall market selloff due to recessionary concerns.
79
March 17, 2008
6.
Long ABX 07-1 AAs versus ABX 07-1 BBBs: We favor a curve steepener trade
on the 07-1 index.
7.
Long ABX 07-2 AAs versus ABX 07-2 BBB-s: ABX 07-2 yields look
significantly attractive in both the base and the stress case.
80
DETAILS OF CURRENT TRADES IN LEVERAGED PORTFOLIO

Convexity Trades
Trade
Long
Short
Hedge
Equity
Leverage
20
Long 5% IO (FHT 245) vs. Swaps
FHT245 + 2s10s Swaps
Duration hedged
daily
Long 6.5s vs. 5.0s
FN6.5s + 2s 10s Swaps FN 5.0s
1:1 hedged + daily

duration hedges
20
20
Long GN/FN 6.5 swap
GN 6.5s
TBA FN 6.5s
1:1 hedged
10
20
Long DW 5.5 vs. FN 6
DW 5.5
FN 6
Duration hedged
weekly
10
20
Credit Trades as of Close of Day March 14, 2008

Trade
Long
Short
ABX 06-1 BBBs
Hedge
Equity
Leverage
Unhedged
21.0
2.1
ABX 06-2 AAAs versus

ABX 06-1 BBBs/CDX.HY.100.9
ABX 06-2 AAA
ABX 07-1 AAs versus 07-1 BBB
ABX 07-1 AA
ABX 07-1
BBB/BBB-
Unhedged
19.4
1.3
ABX 07-2 AA versus 07-2 BBB-s
ABX 07-2 AA
ABX 07-2 BBB-
Unhedged
18.1
1.4
and CDX.100.9
Credit Trades Opening Prices and Cash Allocation as of March 14, 2008
Start date
Notional (million)
Equity (million)
Initiation Level
Long ABX 06-2 AAAs
3/7/2008
3.4
68
Short ABX 06-1 BBB
3/7/2008
20
15.2
14.8
Short CDX.HY.9
2/15/2008
20
2.4
87.5
Long ABX 07-1 AAs
3/7/2008
1.1
21.5
Short ABX 07-1 BBBs
3/7/2008
20
18.3
8.5
Long ABX 07-2 AAs
3/7/2008
1.1
22.5
Short ABX 07-2 BBB-s
3/7/2008
20
17.0
12.8
Long Super-Senior Option ARM AAA (New Trade)
3/15/2008
75
10
7.5
Net Long Trades
25.0
13.1
Net Short Trades
80.0
52.9
Cash
9.0
Total
75.0
March 17, 2008
81
LEVERAGED PORTFOLIO ANALYSIS

Return Statistics
Total Equity
($mn)
YTD P/L ($ mn)
YTD % ROE
1-Week P/L ($mn)
1-Week %
ROE
Total Portfolio
150
19.07
12.72%
-0.38
-0.25%
Convexity Portfolio
75
21.58
28.77%
0.29
0.39%
Credit Portfolio
75
-2.50
-3.34%
-0.67
-0.90%
From close of 12/13/2007

Total
P/L
(bp)
1-Wk
P/L (bp)
Equity
($ mn)
Avg.
Eq
($mn)
Leverage
1 Week
P/L ($
'000)
Total P/L
($ 000)
% ROE
Start date
Short FN 5.0s vs. Swaps
362
43
10
18
380
3326
19.01
12/14/2007
Long 5% IO (FHT 245) Vs Swaps
608
-36
20
20
-350
6273
31.36
12/14/2007
Long 6.5s vs 5.0s
315
16
20
11
20
358
6811
63.85
12/14/2007
Buy GN/FN 6.5 Swap
30
-26
10
10
20
-514
635
6.35
2/8/2008
Buy DW 5.5 vs. FN 6
22
20
10
10
20
405
466
4.66
2/22/2008
Convexity Trades
Credit Trades
Long ABX 06-2 AAAs
80
80
3.4
3.4
1.5
41
41
1.22
3/7/2008
Short ABX 06-1 BBBs
976
181
15.2
11.6
1.3
329
1640
14.12
2/15/2008
Short CDX.HY.9
49
92
2.4
2.4
8.0
180
101
4.13
2/15/2008
Long 07-1 AAs
-70
-70
1.1
1.1
4.7
-35
-35
-3.21
3/7/2008
Short 07-1 BBBs
-203
-203
18.3
18.3
1.1
-398
-398
-2.18
3/7/2008
Long 07-2 AAs
-142
-142
1.1
1.1
4.4
-71
-71
-6.29
3/7/2008
54
-54
17.0
13.3
1.2
-68
126
0.94
2/15/2008
All returns as of close of Wednesday, March 12, 2008

The average equity is the weighted average equity allocated to the position over its life. For instance if we allocated 20 million equity to a trade for
10 days followed by 30 million for the next 5 days, the average equity will be 23 million.
Best & Worst Retired Trades - Last 12 Months

Trade
Leveraged Portfolio ROE Since Inception January 2003
Holding Period
Profit*
1 Buy FN 371 IO vs. FN 6s
7/20/07 - 11/9/07
1,850
80
2 Buy FN 6.5s vs. FN 5.5s
8/3/07 - 12/6/07
1,782
70
3 Buy 2004 FN 5s vs. TBA
12/13/06 - 7/23/07
1,321
4 GD 6s vs. GN 6s
3/30/07 - 7/23/07
1,106
60
5 Sell FN 6 Butterfly
6/1/07 - 6/11/07
936
50
1 Long ABX 07-1 AAs
7/23/07 - 12/6/07
-7,754
2 Long ABX 07-1 As
7/23/07 - 12/6/07
-7,455
40
3 Long ABX 07-2 AAs
12/14/07 - 2/13/08
-3,746
30
4 Long ABX 07-1 As
12/14/07 - 1/23/08
-2,044
20
5 Long 07-1 AAAs
2/15/08 - 3/7/08
-1,534
*($, 000s)
All returns as of 3/12/2008
Cum ROE
10
0
01/03
01/04
01/05
01/06
01/07
01/08
Total ROE = 66.14% since Jan 2003
March 17, 2008
82
12-MONTH ROLLING LEVERAGED PORTFOLIO SUMMARY
RETIRED TRADES
Start
Date
End
Date
$ P/L
(000s)
% ROE
Buy DW 5.5/FN 6.0 Swap Convexity Hedged
12/13/06
03/16/07
20
Buy DW 4.5/FN 5.0 Swap
01/19/07
03/16/07
23
10
25
618
3.09
20
547
Buy DW 6s vs. 2y/10y Swaps
02/05/07
03/16/07
5.47
20
10
242
1.21
Buy TBA FN 5.5 + 6.0% IO vs. TBA 6s
02/12/07
03/16/07
Buy FN 5/1 5.5 Hybrids versus TBAs
02/23/07
03/16/07
-6
15
20
-90
-0.60
30
10
79
0.26
Pay total returns on AAA HEL Index
02/23/07
Buy GN2/FN6 Swap
12/13/06
03/16/07
21
10
10
241
2.41
03/30/07
10
20
324
Sell FN 6 Butterfly
3.24
06/01/07
06/11/07
30
15
20
936
6.24
Buy New WALA GD 6.5 vs. TBA
12/13/06
06/08/07
-1
10
20
248
2.48
Buy ABX 06-2 BBB, pay returns on High Yield

Index, receive on 5yr swaps
02/23/07
06/22/07
-362
10
-186
-1.86
Buy 2004 FN 5s vs. TBA
12/13/06
07/23/07
50
10
20
1321
13.21
Total
Equity
($mn)
Leverage
GD 6s vs. GN 6s
03/30/07
07/23/07
10
30
20
1106
3.69
High LTV 6.5s vs. TBAs
05/18/07
07/20/07
-14
10
20
-188
-1.88
FN 5.5s vs. 2s/10s Swaps
05/29/07
07/23/07
-45
10
10
-368
-3.68
FN 6.5s vs. 2s/10s Swaps
05/29/07
07/23/07
-41
25
10
-809
-3.24
Buy Dwarf 6s vs. 2s/10s swaps
06/15/07
07/23/07
-30
10
20
-540
-5.40
FN 5/1 5.5s versus 2/5s swaps
03/16/07
08/03/07
-51
20
10
-604
-3.02
Buy LLB GD 5.5 vs. TBA 5.5
02/14/07
11/01/07
-14
10
20
97
0.97
Buy Jumbo 6s vs. TBAs
09/17/07
11/01/07
13
20
10
390
1.95
Buy FN 371 IO vs. FN 6s
07/20/07
11/09/07
160
20
1850
9.62
Buy FN 361 IO vs. FN 6s
07/20/07
12/06/07
56
20
931
4.81
Buy FHT 245 IO vs. 2y10y swaps
11/09/07
12/06/07
-59
20
-517
-2.58
Long ABX 07-1 As
07/23/07
12/06/07
-2,608
65
-7455
-24.13
Long ABX 07-1 AAs
07/23/07
12/06/07
-4,076
20
-7754
-38.77
Buy FN 6.5s vs. FN 5.5s
08/03/07
12/06/07
36
20
20
1782
7.41
Sell 3m FN 6s ATM calls vs. 3m2y and 3m10y

swaptions
10/01/07
11/29/07
19
40
418
8.35
Long ABX 07-1 As
12/14/07
01/23/08
-733
30
-2044
-6.81
Long 6% IO Collateral vs. TBA
12/14/07
02/08/08
29
10
210
2.16
Long ABX 07-2 AAs
12/14/07
02/13/08
-1,319
30
-3746
-12.49
Long ABX 06-2 AA vs CDX HY 9
12/14/07
02/13/08
4,445
10
4515
45.15
Long ABX 07-1 AAAs
01/24/08
02/13/08
-126
30
-322
-1.07
Long 5/1 5.5s vs FN 30yr 6.0s
12/14/07
02/29/08
192
19
10
3826
20.09
Long 07-1 AAAs
02/15/08
03/07/08
-1,515
-1534
-21.02
Long ABX 07-1 BBBs
02/15/08
03/07/08
-534
-566
-37.73
Short ABX 07-1 Single-As
02/15/08
03/07/08
498
12
765
6.17
Short ABX 07-2 BBBs
02/15/08
03/07/08
261
12
412
3.32
Long ABX 07-1 BBB-s
02/26/08
03/07/08
-327
-487
-27.08
Long ABX 06-2 AAs
02/15/08
03/07/08
-2,340
-964
-41.93
CURRENT TRADES*
March 17, 2008
83
Short FN 5.0s vs. Swaps
12/14/07
362
18
3326
Long 5% IO (FHT 245) Vs Swaps
12/14/07
608
20
6273
19.01
31.36
Long 6.5s vs 5.0s
12/14/07
315
11
20
6811
63.85
Buy GN/FN 6.5 Swap
02/08/08
30
10
20
635
6.35
Buy DW 5.5 vs. FN 6
02/22/08
22
10
20
466
4.66
Long ABX 06-2 AAAs
03/07/08
80
10
1.5
41
1.22
Short ABX 06-1 BBBs
02/15/08
976
1.3
1640
14.12
Short CDX.HY.9
02/15/08
49
12
8.0
101
4.13
Long 07-1 AAs
03/07/08
-70
4.7
-35
-3.21
Short 07-1 BBBs
03/07/08
-203
1.1
-398
-2.18
Long 07-2 AAs
03/07/08
-142
18
4.4
-71
-6.29
02/15/08
54
1.2
126
0.94
Last 12 Months Statistics

% of Profitable Trades in Last 12 Months
51%
% P/L in Profitable Trades in Last 12 Months
60%
Portfolio Turnover Rate per year
6.4
Average ROE on Winning Trade (weighted average)
8.4%
Average ROE on Losing Trade (weighted average)
-7.5%
*Funding costs are assumed to be the lower of 1M LIBOR, dollar rolls or repo. Details on the trade weightings are provided when the trade is initiated and are
updated on a weekly basis. For P/L purposes, the portfolio is marked every Wednesday at 4:00 pm. For the leveraged portfolio statistics, total face amount of the
long position = equity x leverage. P/L (bp) gives the P/L of the position excluding gains on equity held against the position, while P/L ($) gives the P/L of the
position including gains on equity held against the position. Past performance is not an indicator of future performance.
March 17, 2008
84
ABS
Overview
Strategy
212-526-8312
Akhil Mago
akmago@lehman.com
Rahul Sabarwal
rsabarwa@lehman.com
Jasraj Vaidya
jvaidya@lehman.com
Madhuri Iyer
madiyer@lehman.com
Quantitative Research
Dick Kazarian
dkazaria@lehman.com
Stefano Risa
srisa@lehman.com
Omar Brav
ombrav@lehman.com
Gaetan Ciampini
cgaetan@lehman.com
WEEKLY REVIEW:
FED ACTIONS/S&P COMMENTS SPARK AN ABX RALLY
Though characterized with typical volatility associated with the subprime space, the
ABX indices staged a small rally up-the-capital structure this week sparked by a
combination of Feds liquidity infusion proposal and positive commentary from S&P
around limited future subprime losses. Overall, AAA/AAs prices rallied 1-3 points while
the subordinates sold off by 0.25-2 points. The first positive news of the week came on
Tuesday when the Fed announced infusion of $200 billion of liquidity into the system by
lending Treasuries against collateral including mortgage-backed securities. The ABX
AAAs rallied 1-3 points across vintages following the Fed news, and there was another
AAA/AA mini-rally on Thursday when S&P announced that a majority of subprimerelated losses had already recognized at banks and other financial institutions. However,
the AAA rally was halted on Friday as the AAA ABX indices sold-off in line with the
broader capital markets.
Another notable headline that caught attention this week was the proposal by
Congressman Frank Barney surrounding FHA refinancing between 1 million and 2
million borrowers provided lenders/investors with exposure to the original mortgage
recognize any losses to the extent of the difference between updated value of the
mortgage and the original mortgage. Thus, the overall tone was largely positive this
week and the market even discounted news of potential liquidation of a mortgage fund
run by the Carlyle Group after significant margin calls.
Although market technicals were largely positive this week, on the fundamental side, we
recently revised our loss expectations upward given worsening collateral performance in
the prime space and continued worsening in housing expectations (click here for more
details). However, even with updated loss expectations and the AAA/AA mini-rally this
week, we like the ABX indices up-the-capital structure and recommend the following
trades: long ABX 06-2 AAs versus ABX 06-1 BBBs/CDX.HY100.9; long ABX 07-1
AAs versus 07-1 BBBs; and long ABX 07-2 AAs versus ABX 07-2 BBBs.
Kevin Zhang
Kzhang1@lehman.com
March 17, 2008
85
(Reprinted from ABS Monthly Review, March 14, 2008)
Liquidity Concerns and Asset Liquidations

Lead Resi-Credit Sell-off
The past month saw a continuation of the residential credit sell-off led largely by
increased liquidity concerns and forced asset sales from various mortgage-related funds.
For example, in the subprime space, ABX indices continued their downward slide,
selling off 5-20 points across the capital structure with the most significant sell-off at the
AA/A level. In the non-agency prime world as well, prices moved out by 5-15 points on
fears of increased supply from asset sales and liquidity issues. Spillover effects were also
felt in the agency space, where spreads widened to unprecedented levels. However, there
was some respite over the last few days as the Fed tried to tackle the liquidity issue by
infusing $200 billion into the system by deciding to lend treasuries against collateral
including MBS. In addition, positive headlines around Congressman Barney Franks
proposal of potential FHA refinancing of 1 to 2 billion borrowers and S&P expectations
of limited future subprime losses sparked a mini-rally in the ABX AAA/AA indices this
past week.
On the fundamental side, though performance continues to worsen across all residential
credit sectors, in recent months prime non-agencies have underperformed versus
subprime (ABX remits this month were largely in line with expectations). Given
worsening performance, we update our loss expectations across sectors based on statelevel HPA projections. In our base case, which corresponds to an annual OFHEO
national headline HPA of -5% in 2008-09 and a 35%-40% home price drop in California,
we project 2006 vintage losses of 26% on subprime and 10% on Option ARMs.
Despite higher loss expectations, we continue to like the ABX indices up the capital
structure. Our top trades are: long ABX 06-2 AAs versus ABX 06-1
BBBs/CDX.HY.100.9, long ABX 07-1 AAs versus 07-1 BBBs, and long ABX 07-2 AAs
versus 07-2 BBBs.
Our key themes this month:
March 17, 2008
Performance in Negative HPA: Effect of negative equity on performance
February Remittance: Improved Prepays, Credit Worsening Continues
Updated Loss Expectations: Cum Loss Estimates across Sectors
ABX Relative Value: Favor Long up the Capital Structure
Consumer ABS: Spreads Continue to Widen
86
HEL:
Subprime Performance in a Negative HPA
Environment
NO SIGNS OF EXPONENTIAL WORSENING
IN PERFORMANCE WITH NEGATIVE HPA
With the continued housing slowdown, there has been a huge increase in the balance of
loans with negative equity, which has fueled concerns of a further rise in delinquencies
due to reduced borrower incentive to make mortgage payments. The key question in this
context is whether sensitivity of subprime performance becomes more levered to HPA as
HPA declines significantly below zero. Against this backdrop, we evaluate sensitivity of
subprime performance to HPA for 2006 vintage where about 20% of loans have negative
equity. (Click here for details)
On both the credit and prepayment side, we see a linear sensitivity of performance to
HPA. On the credit front, while we saw worsening in delinquencies, there were no signs
of an exponential deterioration in a negative HPA environment. For example, 60+
delinquencies increased by 1.0%-1.5% point for every 1% point drop in HPA, which is
similar across both positive and negative HPA buckets. On the loss severity front,
sensitivity to HPA seems to decline for lower HPA buckets, which can be explained by
higher loan balances with low HPA and adverse selection of borrowers who default
despite a high MSA level HPA. With respect to prepays, they again vary linearly with
HPA, with both voluntary and total prepays changing by about 1% for a 1% change in
HPA .
The trend in performance of more levered mortgages, such as high CLTV loans is also
similar to the overall sector. However, since high CLTV loans are more reliant on equity
cash-out and least likely to make payments as HPA declines, their credit and prepayment
sensitivities to HPA are higher. For example, delinquencies have changed by about 1.5%2.0% point for every 1% point change in HPA for 90-100 CLTV 2006 vintage loans.
Although the absolute level of sensitivities is higher for high CLTV loans, sensitivities
have been linear across HPA buckets along the lines of the overall subprime universe. As a
side point, the 2006 vintage is less sensitive to HPA than the 2003 vintage (click here for
historical sensitivities).
March 17, 2008
87
ABX:
Update on the February Remittance Performance
CREDIT DETERIORATION AND PREPAYS
SLIGHTLY SLOWER THAN LAST MONTH
There were no major surprises in store in the February remittance as overall performance
deviated only slightly from the trend observed over the past few months. On the credit
side, there was some letup in the deterioration in performance as delinquencies rose at a
pace slightly lower than that observed over the past few months across the indices. An
interesting trend in recent remits has been the sharp increase in balance of delinquent
loans on the ABX 06-2 index post-reset largely attributed to payment shock. On the
prepayment side, speeds have been oscillating between increasing and decreasing every
alternate month and it was the turn of the downtick this month as overall prepays slowed
by 1%-2% CPR on a month-over-month basis.
While credit performance continued to deteriorate on a month-over-month basis in the
latest remittance, the pace of deterioration this month was slightly lower than that
observed last month across the ABX indices. In fact, the monthly increase in
delinquencies on the ABX 07-1 index in the February remittance is the lowest observed
over the past five months. Another interesting trend in recent remits is the post-reset
spike in balance of delinquent loans on the 06-2 index due payment shocks.
On the prepayment front, month-over-month prepays declined by about 0.5%-2.5% CPR
across ABX indices, which is in contrast to the general increase observed in the January
remittance for all indices except the 06-1 index. The most significant decline in prepays
was observed on the 06-1 index where speeds declined by about 2.5% CPR compared
with last month. Even for ABX 06-2 index deals, where loans are hitting reset,
prepayment declined by about 0.75% CPR as opposed to a 1.9% CPR increase last
month.
March 17, 2008
88
Residential Credit:
Updated Loss Expectations
across Residential Credit
WE EXPECT BASE-CASE SUBPRIME LOSSES
OF 26% ON THE 2006 VINTAGE
With deteriorating performance of non-agency mortgages, we re-evaluate loss
expectations across residential credit sectors in this section. Our analysis is based on
estimates of forward HPA by sectors, which depend on our state-level HPA assumptions
and the exposure of different sectors to states. In our base case, we expect a 16% drop in
home prices nationally over the next three to four years in order to bring home prices in
line with rents/income. This equates to a 35%-40% peak-to-trough drop in house prices
in California/Florida. In our pessimistic scenario, we expect a 10% annual drop in
national home prices in 2008-09. Given differences in geographical concentration, our
base case translates into more stressful HPA for California centric sectors such as Option
ARMs than the national headline. For example, we forecast an annual drop of 11% in
OFHEO HPA during 2008-09 for Option ARMs. Other sectors could experience an 8%10% drop in annual OFHEO HPA in 2008-09.
Based on a sector-level HPA forecast, we expect base case cumulative losses on 2006
vintages to be around 26% for subprime and 10% for Option ARMs. In our pessimistic
scenario of -10% annual national OFHEO HPA, 2006 losses are likely to increase to 30%
for subprime and 13% for Option ARMs. As expected 2007 vintage losses are more
severe given more pronounced decline in home prices on these vintages. Overall, these
cumulative loss estimates are based on expected severities combined with expected
defaults from a roll rate analysis to arrive at base case cum loss estimates for a -5%
headline HPA scenario. To arrive at losses across HPA scenarios, we use the observed
sensitivities of 2006 vintage performance to HPA (click here for details).
March 17, 2008
89
ABX:
Relative Value Views and
Credit Leveraged Portfolio
ABX VALUATIONS STILL ATTRACTIVE
AT THE TOP OF THE CAPITAL STRUCTURE
Based on our new methodology, we have revised our ABX loss expectations upwards,
expecting about 23% and 30% cumulative loss on ABX 06-2 and ABX 07-1 indices,
respectively. Despite our higher loss expectations, we still like up-the-capital structure
trades on the ABX paired with shorts down the capital structure. Our top longs are likely
to yield 10%-15% in our base case with a stable yield even in a stress scenario. From the
short side, we argue for shorting indices that yield low returns in the base case and are
significantly levered to a housing downturn. Our top trades are long ABX 06-2 AAAs
versus 06-1 BBBs and CDX.HY100.9, long 07-1 AAs versus 07-1 BBBs/BBB-s, and
long 07-2 AAs versus 07-2 BBB-s.
Although we like the ABX indices up the capital structure versus the BBB/BBB-s even
at higher loss levels, we have positioned our Credit Leveraged Portfolio net short given
current bearish conditions with $53 million equity in the long trades and $13.1 million
equity in the short trades. All our ABX views moved in our favor last week, however
accounting for the bid-offer spread leaves us net negative in the week, with an ROE of
-0.9%. Over the past month, our ROE is -1.6%.
This week, we add a long position in 2006 vintage Option ARM Super Senior AAAs off
XS/OC deals which are trading at $75/100. We add notional exposure to $10 million of
Super-Senior AAAs to our Credit Leveraged Portfolio. We think yields on these bonds
are attractive, with limited downside risk as the bonds are well protected from losses in
our stress case performance scenarios as well.
Summary of Recommended Trades
Total Equity ($mn)
YTD P/L ($ mn)
YTD % ROE
1-Week P/L ($mn)
75
-2.50
-3.34%
-0.67
Credit Portfolio
Initiation
Price
Curren
t
Price
Total
P/L
bp)
1-Wk
P/L
(bp)
Equity
($ mn)
Avg.
Eq
($mn)
Leverag
e
1-Wk
ROE
-0.90%
1 Wk
P/L
($ '000)
Total
P/L
($ 000)
%
ROE
Start
date
Long ABX 06-2 AAAs
68
68.75
80
80
3.4
3.4
1.5
41
41
1.22
3/7/2008
Short ABX 06-1 BBBs
27.5, 14.75
16.75
976
181
15.2
11.6
1.3
329
1640
14.12
2/15/2008
2/15/2008
Short CDX.HY.9
87.5
87.25
49
92
2.4
2.4
8.0
180
101
4.13
Long 07-1 AAs
21.5
20.75
-70
-70
1.1
1.1
4.7
-35
-35
-3.21
3/7/2008
Short 07-1 BBBs
8.5
10.5
-203
-203
18.3
18.3
1.1
-398
-398
-2.18
3/7/2008
Long 07-2 AAs

Long 06-SS AA Option ARM
22.5
21
-142
-142
1.1
1.1
4.4
-71
-71
-6.29
3/7/2008
16.25, 12.75
14.75
54
-54
17.0
13.3
1.2
-68
126
0.94
2/15/2008
75
3/14/2008
The CDX HY return includes the one-time payoff due to a default of one name in the index. We increased exposure to the short ABX 06-1 BBB and short
ABX 07-2 BBB- trades by $5 million on 3/7/08. We indicate both initiation prices in the figure above from earliest to latest initiation date.
March 17, 2008
90
Consumer ABS:
Auto, Credit Cards, Student Loans
SPREADS CONTINUE TO WIDEN
Spreads continued to widen across consumer ABS sectors, reaching new highs in
February. Spread curves continued to steepen. In Autos, the three-year BBB spread
widened 115 bp and is currently trading at 665 bp spread to swaps; three-year AAA
spread widened 70 bp and is currently trading at 195 bp. Persistent negative headlines on
the macro front along with poor technicals seems to be driving spreads wider.
February saw $5.6 billion in ABS issuance, with $2.5 billion in credit cards, $1.6 billion
in autos, and $1 billion in student loans. This was sharply lower than the $19 billion seen
in January. The credit performance of consumer ABS deteriorated modestly, driven by
the softening in the labor market. Charge-Offs on the major credit card trusts went up by
an average of 20 bp. Delinquencies and defaults in autos continued to climb. The
weakening in performance seems to be outpacing the weakening in the labor markets.
The 2007 vintage continues to perform worse than the earlier vintages.
March 17, 2008
91
CMBS
Market Monitor
Neil Barve
212-526-8313
nbarve@lehman.com
Aaron Bryson
212-526-8313
aarbryso@lehman.com
Wei Jin
212-526-9956
wejin@lehman.com
Tee Yong Chew
212-526-8313
teeyong.chew@lehman.com
CMBS spreads widened over the week in volatile trading action. A main theme across
both the cash and synthetic markets was credit curve steepening. Ten-year 30% credit
support AAA spreads ended the week 10 bp wider, while generic BBB spreads widened
an additional 225 bp, to S+2025 bp. In CMBX, we saw a divergence versus the cash
market as AAA-rated classes were close to unchanged in most series, leading to a
widening of the gap between cash and synthetic securities. Sentiment improved early in
the week after the latest Fed policy maneuver on Tuesday and the rebound in broader
credit and equity markets. However, this improvement was short-lived, given further
hedge fund liquidations and the Bear Stearns funding news on Friday. Any initial
positive reaction evaporated, overcome by financial sector weakness.
Despite getting trumped by negative headlines later in the week, we believe the Feds
latest attempt to improve liquidity in credit markets, the Term Securities Lending
Facility, could eventually have a marginally positive indirect impact on AAA senior
CMBS. The facility allows primary dealers to pledge non-agency AAA residential
mortgage assets (that are not on downgrade watch) as collateral for Treasuries, for a term
of up to 28 days. The first auction is set for March 27.
Summary of Relative Value Recommendations

Basis:
Overweight CMBS; strong credit characteristics and recent underperformance versus other fixed income sectors
Credit Curve:
Underweight BBBs; overweight AAAs through A; generic new issue BBB/BBB- spreads are at historical wides but we
see significant downside in a stressed scenario; also, weak technicals currently dominate
Favor discount current pay AAAs; upside from potential pickup in near-term defaults, low spread duration
Specific Trades:
Cash Only
Buy AM classes versus super duper-AJ combo: AMs offer strong credit protection and best convexity
Cross-Sector
Buy AAA 5-year CMBS, buy protection on CDX.NA.IG.OTR, pay on interest rate swap
Synthetic Only
Sell protection A.3, buy protection A.2
Sell protection 2.5X AAA.4, buy protection 1X AJ.4
Sell protection AJ.3, buy protection AA.3
Sell protection 0.6X AJ.2, buy protection 1X A.2, buy protection 0.4X BBB.2 (3/14/08)
CMBS Index Monitor
Total Return
Mar. 7-Mar. 13
MTD Mar. 13
YTD 2008
Excess Return Versus:
Treasuries
Mar. 7-Mar. 13
MTD Mar. 13
YTD 2008
Swaps
Mar. 7-Mar. 13
MTD Mar. 13
YTD 2008
AAA SD
AAA
AAA
Current- LockedOut
Pay
All AAA
U.S. Agg.
Comp.
Inv.
Grade
High
Yield
55
-382
-871
17
-429
-985
-395
-914
-1,853
43
-271
-546
74
-381
-878
109
-349
-779
20
-407
-1,351
-18
-454
-1,463
-425
-937
-2,299
18
-291
-968
37
-407
-1,371
68
-374
-1,279
-69
-380
-1,300
-103
-427
-1,412
AA
BBB
BB
67
-357
-806
-484
-1,106
-2,385
-547
-1,218
-2,787
-702
-1,432
-3,072
-520
-1,157
-2,383
33
-381
-1,283
-523
-1,133
-2,882
-586
-1,245
-3,280
-738
-1,458
-3,550
-550
-1,180
-2,847
-56
-355
-1,232
March 17, 2008
92
Although AAA CMBS is not included at this stage, we may see an indirect benefit from
improved liquidity in the non-agency residential market. It could reduce cross-sector
hedging activity of non-agency residential assets with CMBX. However, we believe the
benefit is purely on the technical sideit is unlikely to do anything to improve the
softening fundamentals in commercial real estate markets, highlighted by this weeks
poor retail sales report.
Portfolio Lenders More Competitive
As highlighted last week, portfolio lenders can offer much more attractive terms right
now than CMBS originators. For example, Freddie Mac highlighted on its 2008
investor/analyst conference call on March 11 that its average lending spread on
multifamily properties in February was 141 bp relative to its debt. This translates to loan
spreads of approximately T+203 bp. 1 Meanwhile, 10-year 30% credit support AAA
spreads to swaps ended February at 235 bp, or T+298 bp.
March 17, 2008
Average 10-year agency OTR spreads to Treasuries were 62 bp for February 2008.
93
NEW ISSUE SPREAD MONITOR

Fixed Rate Conduit/Fusion over Swaps (bp)
Floating Rate over 1-mo. LIBOR

6-month
Category
AAA 3-yr.
AAA 5-yr.
AAA 7-yr.
AAA Sup. Dup.
AAA Mezz.
AAA Jr.
AA
A
BBB
BBB-
1-wk.
chg.
35
35
35
10
20
40
105
100
225
225
3/14/08
425
415
420
315
495
790
1025
1325
2025
2225
Avg.
146
164
170
124
189
263
346
509
906
1034
High
425
415
420
315
500
790
1025
1325
2025
2225
6-month
Low
53
52
63
43
63
79
120
195
370
475
Rating
AAA Sup. Snr.
AAA
AA
A
BBB
3/14/08
225
275
350
450
575
1-wk.
chg.
0
0
0
0
0
Avg.
95
121
166
237
344
High
225
275
350
450
575
Low
50
55
85
145
240
Spread Comparison versus Benchmark Sectors

Agency Debentures
Term
5-year
10-year
Fixed-rate ABS
LIBOR
OAS
13
22
CMBS AAA Spd. Pickup

6-mo.
3/13
3/6
avg.
387
382
878
278
291
171
Spd.
(Tsy)
255
252
330
187
CMBS IG Index Spd. Pickup

6-mo.
avg.
3/13
3/6
226
193
-884
229
195
51
151
132
46
226
207
18
Category
Autos AAA
Cr. Cards AAA
HEL AAA
HEL BBB
Credit
Credit index
Industrials
Financials
CDX.IG.OTR*
*Protection Premium
Avg.
Life
3 yr.
5 yr.
5 yr.
5 yr.
Spd.
(LIBOR)
213
130
370
1,970
OAD
0.0
LIBOR
OAS
53
CMBS Spd. Pickup

6-mo.
3/13
3/6
avg.
197
175
1,762
270
270
46
30
30
95
-45
-276
-121
MBS
Current Coupon
CMBS AAA Spd. Pickup

6-mo.
avg.
3/13
3/6
314
280
67
Domestic New Issuance

Cr. Support
#
1
Deal name
N/A
Deal
type
Size
($mln.)
Pricing
date
Jr.
AAA
BBB
AAA
3-yr.
AAA
5-yr.
Pricing Spread (bp over LIBOR)

AAA
(SD)
AAA
AAA
7-yr.
10-yr.
Jnr.
A
BBB
BBB-
Bid List Activity (cash market)

Breakdown by Type of Security
Time Period
Mar. 10-14
Weekly avg. (6-mo.)
Mkt. Val.
($ mn.)
1,637
1,935
AAA.
97%
94%
Mezz.
3%
5%
Non-IG
0%
0%
Agency
0%
0%
IO
0%
0%
Breakdown by Type of Seller

Money
Insurance Bank/
Manager Company
Thrift
Other
35%
1%
11%
53%
61%
15%
7%
17%
This represents all the CMBS bid lists that Lehman Brothers saw in the past week; not all securities necessarily traded.
Source for all tables on this page: Lehman Brothers unless otherwise specified.
March 17, 2008
94
THE SYNTHETIC SUPPLEMENT

CMBX/CDS Spread Monitor
CMBX.NA (Composite)
CMBX.NA (Composite)
6-month
Rating
AAA.4
AJ.4
AA.4
A.4
BBB.4
BBB-.4
BB.4
1-wk.
chg.
2
9
70
124
254
343
277
3/14/08
263
710
927
1184
1958
2280
2432
Avg.
133
337
459
653
1198
1404
1720
High
277
753
928
1184
1958
2280
2432
6-month
Low
58
135
248
355
798
983
1349
Rating
AAA.1
AAA.2
AAA.3
BBB.1
BBB.2
BBB.3
3/14/08
212
230
254
1164
1554
1983
1-wk.
chg.
7
-10
2
209
254
248
Avg.
104
114
125
570
800
1105
High
223
251
269
1164
1554
1983
Low
41
43
48
293
468
651
Source: Markit Partners, Lehman Brothers. 6-month statistics and weekly change based on chained index (Series 1, 2, 3 & 4).
Basis Watch
CMBX-Cash
CMBX 4 vs. 3
CMBX-Cash
500
CMBX 4 vs 3
250
400
200
300
150
200
100
100
50
BBB
3/
14
/0
8
1/
11
/0
8
11
/9
/0
7
6/
07
11
/9
/0
11 7
/2
3/
07
12
/7
/0
12 7
/2
1/
07
1/
4/
08
1/
18
/0
8
2/
1/
08
2/
15
/0
8
2/
29
/0
8
3/
14
/0
8
AA
10
/2
AJ
9/
7/
07
3/
2/
07
AAA
7/
6/
07
-50
5/
4/
07
-100
12
/2
9/
06
BBB-
Source: Markit Partners, Lehman Brothers
AAA
Index
AAA
Eligible for U.S. Agg.
AAA SD 8.5+ yr.
AAA 8.5+ yr.
BBB 8.5+ yr.
367
378
298
386
1767
AA
BBB
BBB-
Source: Markit Partners, Lehman Brothers
Index Swaps (Lehman Brothers CMBS Indices)

Avg.
Spd.
AJ
Cross Market Comparison: ABX-HE-06-2
Index Swap Financing Levels (Mid Mkt.)*

6-month
1-wk
3/13/08
Chg
Avg.
High
Low
-150.0
-150.0
-100.0
-700.0
-650.0
0.0
0.0
50.0
-150.0
200.0
18
18
-64
-46
-310
-350
-350
-350
-1050
-850
200
200
250
350
-250
Rating
AAA
AA
A
BBB
BBB-
3/13/08
631
1731
2534
3157
3117
1-wk
Chg
(61)
(74)
(14)
7
11
Avg.
299
998
1812
2746
2798
6-month
High
Low
713
1824
2548
3154
3112
68
181
754
1859
2090
*Negative numbers imply sub-LIBOR financing for the receiver of a total return swap
Source: Lehman Brothers, Markit Partners
March 17, 2008
95
Trade Idea in Index Swaps

The Lehman Brothers AAA 8.5+ year index (duration-neutral) has traditionally been the
most actively traded CMBS index swap contract. At the end of January, the CMBS
AAA super duper indices were launched (see February 1 CMBS Weekly), and swaps
based on the SD 8.5+ year index started trading shortly thereafter. Over the past month
and a half, trading in both these long AAA indices has been very active. But just in the
past few trading days, an interesting disconnect has emerged between the financing
levels of the two contracts. In Figure 1, we show mid-market financing levels for the two
contracts; they were nearly on top of each other at the end of January, but are currently as
much as 600 bp apart, on a mid-market basis. The AAA 8.5+ year index was trading with
a 500-900 bp market on March 14, compared with 0-200 bp for the AAA SD 8.5+ year
index.
In our view, this disconnect can be attributed to the differences in the composition of the
two indices. Mezzanine AAAs (AMs) and junior AAAs (AJs) comprise 18% and 12% of
the AAA 8.5+ year index, respectively, while the SD 8.5+ year index is composed
exclusively of dupers. Hence, all things equal, receivers have a preference for the SD
8.5+ year index and payers/hedgers prefer the AAA 8.5+ year index. These preferences
are now reflected in the relative financing levels of the two indices.
This gives rise to a trade opportunity: Receive the AAA 8.5+ year index at +500 bp
financing and pay the AAA SD 8.5+ year index at +200 bp financing. For a 6-month
tenor on both legs, this locks in a carry of roughly 194 bp (see Figure 2 for details). The
downside to this trade is AMs and AJs widen substantially relative to dupers, causing the
AAA 8.5+ year index to underperform the SD 8.5+ year index. The breakeven level of
widening can be estimated. Assuming a 7-year spread duration, the trade loses money if
the AAA 8.5+ year index widens by more than 28 bp (194 bp/7) relative to the SD 8.5+
year index. This is no mean feat, given that 70% of the AAA 8.5+ year index is
essentially identical to the SD 8.5+ year index. 2
Figure 1.
Mid-market Financing Levels: AAA 8.5+ Year

and AAA SD 8.5+ Year Indices
1200
1000
800
600
400
200
0
-200
-400
1/28/2008
2/4/2008
2/11/2008
2/18/2008
AAA 8.5+
2/25/2008
3/3/2008
3/10/2008
AAA SD 8.5+
March 17, 2008
In reality, 5% of the AAA 8.5+ year index is represented by multifamily-directed classes. For the purpose of this
exercise, we will treat them identical to dupers because of their 30% credit support.
96
Hence, the uncommon elements (the AMs and AJs) will need to show significant
widening relative to the common elements (the dupers) for the trade to lose money.
Given their 30% combined weighting in the AAA 8.5+ year index, we estimate that AMs
and AJs would need to widen more than 93 bp versus dupers (on a weighted average
basis) over six months for the trade to lose money (28 bp breakeven widening / 30%
weight of AMs and AJs = 93 bp).
In what overall environment could AMs and AJs widen by 93 bp relative to dupers? In
the past two years (including the difficult recent months), spread changes on dupers,
AMs and AJs have been highly correlated, with AMs moving with a beta of 1.4x and AJs
with a beta of 2.2x relative to dupers (Figures 3 and 4). If this relationship continues,
dupers would need to widen by more than 130 bp over the next six months for this longshort index swap trade to lose money, assuming that AMs and AJs would then widen by
roughly 182 bp and 286 bp, respectively. Such a move would result in a combined
widening of 224 bp for the two (3:2 weighting for AM and AJ), which would be 94 bp
greater than the widening in dupersthe breakeven level.
We think this is a risk worth taking. Although a widening of 130 bp in dupers over the
next six months cannot necessarily be ruled out given todays uncertain technical
environment, it is a pretty attractive breakeven threshold. Overall, we think that this is a
cautious way of expressing a bullish view on AAA spreads with relatively muted risk to
the downside.
Figure 2.
Carry Breakdown
Financing Spread (bp)

Average Spread (bp)
AAA 8.5+ Year Index
SD 8.5+ Year Index
Carry
Receive @ 500
Pay @ 200
300
386
298
88
300 + 88
= 194
2
Total Carry for 6 months (bp)
Figure 3. Weekly Spread Changes: Dupers versus AMs
Figure 4. Weekly Spread Changes: Dupers versus AJs
140
250
y = 1.3676x
R2 = 0.9126
120
100
200
100
AJ
AM
60
40
50
20
0
-40
-20
-20 0
20
40
60
80
-40
-20
-50
-40
-60
March 17, 2008
20
40
60
80
-100
Duper
y = 2.1659x
R2 = 0.808
150
80
Duper
97
CMBX Update
The main themes this week in CMBX were intra-week volatility, credit curve steepening,
and vintage tiering. Most lower-rated classes touched new all-time wide levels, while
senior AAAs were largely firm despite some widening in the cash market (Figure 1). We
add a new trade to our CMBX portfolio this week; it embeds a credit barbell strategy
designed to exploit the wide range of potential outcomes for cumulative losses in recent
vintages. This trade is designed to perform well in tail scenarios: a severe commercial
real estate recession and, to a lesser extent, a period of relatively strong growth and low
defaults. Furthermore, on a daily basis, we expect the directionality of the trade to be
limited.
Our updated trade recommendations are highlighted below. We maintain our focus on
long/short relative value trades, despite what we see as a fundamental disconnect
between spreads and our expectations of credit losses. We expect technical factors to
continue to trump fundamentals in the near term.
Sell protection 1X AJ.3, buy protection 1X AA.3
Sell protection A.3, versus buy protection A.2
Sell protection 2.5X AAA.4, buy protection 1X AJ.4
Credit barbell strategy: Sell protection 0.6X AJ.2, buy protection 1X A.2, sell
protection 0.4X BBB.2 (ADDED 3/14/08)
Market Update
CMBX trading was extremely choppy this week, as market participants reacted to a host
of major headlines. For the week, higher-rated classes sharply outperformed lower-rated
classes, adjusted for historical spread change betas. We continue to see value higher up
the capital structure; however, we are gradually becoming less bearish on lower-rated
classes. In addition, we saw significant vintage tiering with most equivalent rated classes
of Series 3 underperforming Series 4, pushing the Series 4 versus 3 basis into negative
territory (Figure 2).
Figure 1.
Implied PricesCMBX.4
Implied Price
100
90
Figure 2.
3/7/2008
3/14/2008
84.2 83.9
4 vs 3
250 Basis
AAA
A
AJ
BBB
AA
BBB-
200
80
70
Series 4 versus 3 Basis
64.2 63.5
60
61.4
58.4
62.9
150
58.1
100
49.8
50
43.7
44.4
37.8
40
50
0
30
-50
20
-100
10
0
AAA
AJ
March 17, 2008
AA
BBB
BBB-
-150
12/31/07 1/14/08
1/28/08
2/11/08
2/25/08
3/10/08
98
More Pain for Lower-Rated Classes
Lower-rated classes continue to underperform across all Series. BBB/BBB- implied

prices are trading well below $50 for most contracts, implying significant writedowns.
The average timing of loss is a key component of fundamental value and subject to large
uncertainty. Even if you assume 100% writedowns on the underlying 25 BBB- bonds in
Series 4, a seller of protection earns LIBOR flat returns if the average timing of principal
writedown is no sooner than 4.9 years from today 3 (Figure 3). Although we expect
significant losses in lower-rated classes of recent vintages, we do not expect a notable
surge in near-term delinquencies and defaults in such deals. The average 60+ day
delinquency rate for CMBX.4 deals is 0.08%.
Market Implied Deal Loss
Despite recent credit curve steepening, our market-implied deal loss calculations
continue to show higher implied deal losses in higher-rated classes of a given series
(Figure 7). While we think higher-rated classes are mispriced relative to lower-rated
classes, we would not expect the market-implied deal losses to converge across the
capital structure. In this environment, where expected deal loss is greater than BBBcredit support levels, these contracts represent a long-volatility, option-like payoff profile
for which investors will pay a premium. This is especially true given that we are in the
early stage of a potential commercial real estate downturn.
Super Senior AAA Spread Widening Not Just Credit Related
We have received some requests to extend our loss dispersion approach to super senior
AAAs. We are reluctant to do so, as we believe a large portion of super senior spread
compensation is a liquidity/risk premium to hold high quality securitized assets, not
simply expected credit loss. This risk premium is increasing across all securitized
products, not just CMBS. Such an analysis for super senior AAAs will suggest market
average implied deal losses for CMBX contracts of over 40%, which we believe is the
wrong takeaway.
Figure 3.
10
Breakeven Average Timing of Writedown, Assuming 100% Loss
Average Loss
Timing
(yrs from today)
Avg 60+ day delinquency rate

CMBX.3 = 0.20%
CMBX.4 = 0.08%
8
6.5
5.2
5.6
4.9
4
2
0
BBB.3
BBB-.3
BBB.4
BBB-.4
March 17, 2008
This does not preclude some bonds from taking losses earlier, so long as the average timing is 4.9 years.
99
Trade Update
We add a new trade recommendation, which reflects a credit barbell strategy, designed to
benefit from increased volatility in underlying commercial real estate markets. We
maintain our existing trades, one of which has benefited from recent credit curve
steepening (Figure 4). Our Series 3 versus Series 2 single-A convergence trade has
underperformed, but fundamentally we still find it attractive.
New Trade: Credit Barbell Strategy
We see more value in a combination of AJ and BBB bonds versus single As. Our
preferred trade involves selling protection on AJ.2 (60 units), selling protection on
BBB.2 (40 units), and buying protection on A.2 (100 units). The rationale is as follows:
Trade performs well in extreme adverse scenarios for commercial real estate
markets, given the thicker tranche size of the AJ class (8% on average). For
example, in a dire case where average deal loss rises to say 10%, we expect the net
present value of this trade to be approximately 15 points, based on our loss
dispersion approach (Figure 5). 4 This is because many of the BBB/A classes are
wiped out, while there are still only partial losses to select AJs.
Trade delivers positive returns in low to mid-range deal loss scenarios. In the
extreme, if bond losses were zero across all CMBX.2 BBB bonds, one would simply
collect the positive carry of this trade, which is 116 bp per year (64 bp running
coupon minus 2 point upfront payment; Figure 6). Of course, this is unrealistic as
there will be losses. However, based on our loss dispersion approach, this trade
delivers positive returns across all average deal loss environments.
Trade should exhibit low short-term directionality.
Figure 4.
CMBX Relative Value Trade Performance, As of March 14, 2008

Initial Net
Carry (bp/yr)
Entry
Date
S/I
Return
(bp)*
Monthly
Return
bp)
Sell protection 1X AJ.3, buy protection 1X AA.3
-111
2/15/08
+262
+332
Sell protection CMBX.3.A, buy protection

CMBX.2.A
+114
11/8/07
-314
-47
Sell protection 2.5X CMBX.4.AAA, buy protection

CMBX.4.AAA AJ
+6
1/11/08
-202
-18
Sell protection 0.6X AJ.2, buy protection 1X A.2,

sell protection 0.4X BBB.2 (ADDED 3/14/08)
+116
3/14/08
N/A
N/A
Trade Description

* Performance ignores transaction costs, and assumes that trades are entered at closing Markit composite spread
levels (mid-market).
March 17, 2008
NPV is the sum of each individual trade leg, weighted by the notional value of each leg. The NPV is the sum of
the upfront payment received (paid), the fixed coupon stream received (paid), and estimated notional writedowns
paid (received).
100
Downside Risks
Despite our model results, there are downside risks to this trade. The main drawback
would be an environment where losses on multiple deals breach credit support levels on
BBB securities, but do not reach the single-A level. There is also downside if the average
loss timing is substantially different from our assumed results. For details on our loss
timing assumptions, please see Figure 7. In addition, over the relatively short time series
for which we have data, the trade has been somewhat directional with the change in
spreads. Finally, a drawback of all long/short trades in CMBX is transaction costs.
However, increased trading activity in CMBX is gradually reducing bid/ask spreads,
which makes such trades more appealing. Furthermore, three-legged trades are not
necessarily different from two-legged trades in terms of transaction costs.
Figure 5.
50
Estimated NPV of Trade across Different Average Deal Loss Scenarios
NPV (% of
notional)
40
30
20
10
0
-10
-20
AJ.2/BBB-.2 vs A.2 (-60/-40/100)

AJ.2
A.2
BBB-.2
-30
-40
-50
2
7
8
9
10
Average Deal Loss (%)
11
12
13
14
15
Figure 6.
Trade Details
AJ.2
A.2
BBB.2
Average Credit Support (%)
12.4
7.6
4.4
Average Tranche Size (%)
7.7
1.4
1.1
Notional
(60)
100
(40)
Spread Duration (yrs.)
4.1
3.6
2.2
+653
(898)
+1554
Spread (bp)
Weighted
Average*
+116
Running Coupon (bp)
+109
(25)
+60
+64
Upfront received (paid), bp
+3073
(4566)
+6313
(197)
* Weighted by notional exposure.

March 17, 2008
101
Figure 7.
Relative Value Snapshot as of March 14, 2008
CMBX.4
Current Spread (bp)
Implied Price (100 upfront)
Market Implied Average
Bond Loss; Loss Timing
Avg. Deal Loss
Base Case Average (deal loss = 4.25%)
Fair Spread over dupers (bp)
Mkt. implied/Base case deal loss
2X Base Case Average (deal loss = 8.5%)
CMBX.3
Current Spread (bp)
Avg. Deal Loss
CMBX.2
Current Spread (bp)
Avg. Deal Loss
CMBX.1
Current Spread (bp)
Avg. Deal Loss
AJ
AA
BBB
BBB-
710
63.5
927
58.4
1184
58.1
1958
43.7
2280
37.8
63%; 8.7yr
19.1%
70%; 7.3yr
14.5%
76%; 5.6yr
12.2%
92%; 4.5yr
10.7%
95%; 4.2yr
9.9%
1%; 8.8yr
10
4.5X
4%; 8yr
37
3.4X
10%; 7yr
93
2.9X
31%; 6.9yr
306
2.5X
46%; 6.9yr
488
2.3X
8%; 8.7yr
71
23%; 7.6yr
218
43%; 6.4yr
484
78%; 5.4yr
1242
88%; 4.8yr
1702
731
66.6
952
51.2
1148
46.5
1982
33.2
2311
32.2
60%; 7.9yr
18.3%
65%; 6.6yr
13.2%
69%; 5.5yr
10.8%
89%; 4.6yr
9.3%
93%; 4.1yr
8.6%
1%; 8yr
8
4.9X
4%; 7.4yr
37
3.5X
9%; 6.7yr
95
2.9X
31%; 6.6yr
345
2.5X
47%; 6.6yr
560
2.3X
7%; 8yr
64
20%; 6.9yr
219
38%; 6.1yr
480
75%; 5.3yr
1308
87%; 4.7yr
1820
653
69
795
57.7
898
54.4
1554
36.8
1920
30.5
54%; 8.1yr
18.2%
57%; 7.1yr
13.4%
58%; 5.7yr
10.4%
78%; 5yr
8.7%
86%; 4.7yr
8.2%
1%; 8.1yr
5
5.2X
2%; 7.5yr
23
3.8X
6%; 6.7yr
67
3X
23%; 6.5yr
264
2.5X
36%; 6.5yr
443
2.3X
5%; 8.1yr
49
14%; 7.3yr
157
29%; 6.1yr
358
64%; 5.5yr
1035
77%; 5.1yr
1473
476
77.5
593
68.6
696
64.8
1164
49.2
1388
43.9
38%; 7.4yr
15.7%
43%; 6.8yr
11.7%
46%; 5.7yr
9.1%
65%; 5yr
7.3%
74%; 4.8yr
6.8%
0%; 7.2yr
2
5.7X
1%; 7yr
9
4.3X
3%; 6.5yr
36
3.3X
13%; 6.2yr
154
2.7X
22%; 6.3yr
254
2.5X
2%; 7.4yr
26
8%; 7yr
89
16%; 5.9yr
209
46%; 5.5yr
673
60%; 5.3yr
950
March 17, 2008
102
Figure 8.
Factoring in a Risk Premium*
CMBX.1, LIBOR Flat vs. LIBOR+ Risk Premium

Mkt Implied
25% Deal Loss
LIBOR flat
LIBOR + Risk Premium
20%
25%
20%
15.7%
15%
Mkt Implied
Deal Loss
11.7%
10%
10.2%
9.1%
18.2%
16.3%
15%
13.2%
LIBOR flat
13.4%
12.2%
10.4%
8.1%
7.3%
10%
6.1%
6.8%
9.6%
8.7%
7.9%
5%
5%
0%
0%
AAA AJ
AA
BBB
BBB-
AAA AJ
AA
BBB
CMBX.3, LIBOR Flat vs. LIBOR+Risk Premium
25%
20%
8.2% 7.6%
6.0%
Mkt Implied
Deal Loss
LIBOR flat
20%
18.3%
16.9%
15%
25%
Mkt Implied
Deal Loss
19.1%
10.8%10.3%
10%
9.3% 8.8%
8.3% 8.3%
5%
18.2%
14.2%
13.0%
15%
13.2%
12.3%
LIBOR flat
BBB-
11.7%
11.0%
10%
10.0%
9.3%
9.1% 8.6%
5%
0%
0%
AAA AJ
AA
BBB
BBB-
AAA AJ
AA
BBB
BBB-
* Based on our loss dispersion approach; target returns for seller of protection in LIBOR+ risk premium case are: L+200 bp for AJ, AA, A and L+400 for BBB,
BBB-.
March 17, 2008
103
European Structured Products

Technicals Turn Even More Negative
Krishna Prasad
44-207-103-7899
kprasad@lehman.com
David Covey
44-207-103-9164
dcovey@lehman.com
Sriram Soundrarajan
44-207-103-6857
ssoundar@lehman.com
Aleksandar Devic
44-207-103-5408
adevic@lehman.com
Ashish Keyal
44-207-102-9037
askeyal@lehman.com
Last week, we noted how negative technicals had become in ABS. Credit spreads were
widening, ABX and CMBX prices plummeting, and hedge funds were struggling to
make margin calls. This week, Bear Stearns was forced to obtain emergency funding
from JP Morgan and the Federal Reserve Bank of New York. Bears long-term ratings
were cut by S&P from A to BBB. The Fed put out a short press release indicating that it
is closely monitoring market developments and that it unanimously approved the
arrangement between Bear, JP Morgan, and the NY Fed.
Credit markets in the U.S. and Europe widened on the news, but after the initial shock
wore off, many indices rebounded. Itraxx main widened 5-10 bp but ended up not far
from opening levels of the high 150s. As of 6:00 pm London time, CMBX AAAs had
changed little and ABX AAA prices fell 1-2 points. The FTSE 100 and S&P 500 indices
were down 1%-2% on the day.
The Bear Stearns announcement overshadowed a fairly active week in European ABS.
GMAC announced that it was stopping lending in the Netherlands, some large banks
were downgraded (A&L, Washington Mutual), and U.K. Chancellor Alastair Darling
presented the Treasurys proposals for opening up the mortgage market. Perhaps more
interesting, activity in cash picked up noticeably mid-week; more sellers than weve
become accustomed to emerged with a willingness to accept bids at market levels. This
came on the heels of announcements by central banks that they would provide banks and
primary dealers with an additional $250 billion of lending facilities. In addition to the
usual spate of Dutch and U.K. prime AAAs, some U.K. non-conforming AAAs and
prime single-As traded. The breadth of client activity indicates a modest pickup in
appetite for the product at wide spread levels. Activity slowed on Thursday and Friday.
U.K. prime AAA CDS ended the week about 20 bp wider, at 220 bp. As much as we
fundamentally favor going long at these levels, we are wary of the technicals and, thus,
recommend going long only as part of a long-term portfolio-building exercise. Hedge
funds and/or financials could be the subject of further negative headlines, as liquidity
conditions continue to put a strain on the market. Risks seem skewed toward wider
spreads in the near term, in our view.
March 17, 2008
104
News In Brief
GMAC REPORTEDLY HALTS MORTGAGE ORIGINATIONS
IN THE NETHERLANDS
According to media reports, GMAC has ceased mortgage lending in the Netherlands.
There are 17 GMAC Dutch RMBS outstanding (E-MAC and EMACP shelves), with the
most recent printed in February 2008. GMAC has also issued RMBS deals backed by
U.K. non-conforming (RMAC and RMACS programs), as well as backed by German
mortgages (E-MAC DE shelf).
UPGRADES OF SEASONED U.K. NON-CONFORMING DEALS
Fitch has upgraded the outstanding Leek deals issued prior to 2006 (Leek 11-16) and
affirmed two transactions issues in 2006 (Leek 16 and 17). Leek has been among the
best-performing programs in the U.K. non-conforming sector, and Fitch said the
upgrades were based on a combination of deleveraging and relatively good performance.
Fitch also affirmed four deals from Rooftop, i.e., Farringdon 1 and 2 and Mansard
mortgages 06-1 and 07-1. In our view, more seasoned U.K. non-conforming deals benefit
significantly from the cumulative HPA and the deleveraging of the capital structure
achieved thus far.
U.K. GOVERNMENT ANNOUNCES INITIATIVES
TO SUPPORT THE MORTGAGE MARKET
The U.K. Chancellor of Exchequer delivered his budget speech in the House of
Commons and also touched on the mortgage market. The speech did not make specific
reference to the mortgage kitemarking we discussed last week (click here). However, the
Treasury has published a Housing Finance Review that discusses certain initiatives
intended to support the U.K. mortgage market. The Treasury intends to form a working
group, composed of the mortgage industry, investors, the Treasury, the Bank of England,
and the FSA, to produce suggestions for improving liquidity in the mortgage market.
Other initiatives discussed in the document include making it easier for lenders to
develop long-term fixed-rate mortgage products, as well as encouraging innovation in the
mortgage space.
ALLIANCE AND LEICESTER DOWNGRADED BY S&P
S&P cut A&Ls long-term counterparty credit ratings to A from A+. It also affirmed the
firms short-term rating at A-1. These rating actions do not have an immediate effect on
the Fosse master trust. The short-term ratings (P-1/F-1+/A-1, Moodys, Fitch and S&P,
respectively) from all three agencies are well above the substation and reserve fund stepup trigger levels. Moreover, the long-term rating by Moodys and Fitch (Aa3/AA-,
respectively) would need to fall by four notches before the reserve fund trigger levels
were breached (click here for our weekly of February 15, 2008, for more details).
March 17, 2008
105
Credit
Markets neither Shocked nor Awed
but Hope Endures
Ashish Shah
212-526-9360
ashish.shah@lehman.com
Bradley Rogoff, CFA
212-526-7705
brrogoff@lehman.com
Michael Anderson, CFA
212-526-7745
mhanders@lehman.com
Sherif Hamid
212-526-6561
sherif.hamid@lehman.com
The market liquidity situation has continued to worsen. In response, the Fed has begun
more aggressive intervention. There was last Fridays first salvo: the upsizing of the term
auction facility (TAF) by $40 billion and the proposed $100 billion of term repurchase
agreements. Then on Tuesday, in another innovative move, the Fed initiated a $200
billion Term Securities Lending Facility. Finally, on Friday morning, the New York
Fed and JP Morgan Chase provided 28-day secured financing to Bear Stearns. That said,
the effects of these actions from the Fed appear to have been muted by negative
fundamental headlines, deteriorating liquidity conditions, and weak market technicals.
As we go to print, CDX IG is trading at approximately 190 bp, a few basis points off of
the all-time wides reached earlier this week. Although the central banks moves have not
had the desired stabilizing effect so far, we do take some solace in the fact that the Fed is
clearly on the case.
First, a few thoughts on the Fed action (more fully discussed in our note earlier this
week). Over the past week, the Fed has provisioned approximately $240 billion of
incremental liquidity (for less liquid assets). We view these actions as clear positives, as
they demonstrate to the market that the regulatory authorities are focused on improving
the currently weak liquidity environment. We note that the Fed is developing many nontraditional tools to attack the liquidity crisis and is demonstrating a willingness to use
such innovative approaches.
However, in the broader context of this global liquidity crisis, the Feds action does not
strike us as sufficient. In light of the muted response, it appears that the market agrees
with our assessment. Given the Feds failure to stabilize markets thus far, the Lehman
Brothers economics team has increased its estimate for next weeks Fed Funds rate cut to
75 bp. As our economics colleagues put it: The Federal Reserve will not sit back and
watch the economy or financial markets collapse. If at first they don't succeed, we
believe they will try, try again.
Recent headlines would appear to support further intervention. This weeks U.S.
macroeconomic news remained weak, highlighted by weak retail sales numbers and
continued elevated jobless claims. The bailout of Bear Stearns is further evidence of the
persisting weak liquidity environment. More positively, Friday mornings better-thanexpected CPI numbers should likely free the Fed to pursue further accommodative
policy. Globally, however, inflation expectations remained elevated both in Europe and
Asia, where China reported that CPI growth surged to 8.7% in February. Commodity
prices made new highs this week as well, with oil topping $110/barrel for the first time.
These persisting inflation worries could limit accommodative policy action outside of the
U.S., further exacerbating the current crisis.
Other company-specific news provided little relief. In a further sign of stress on the
mortgage market, Carlyle Capital, the mortgage fund that recently came under pressure,
stated this week that it had failed to reach agreement with its lenders and thus expected
them to promptly seize collateral. Earnings news remained largely negative, with
Blackstone and Liz Claiborne Inc reporting weaker than expected results and several
issuers reducing 2008 guidance. In a mild positive, the WSJ reported that a U.K. hedge
fund had approached Washington Mutual about a potential capital infusion. The notion
March 17, 2008
106
that some investors are beginning to see opportunity in the stressed financial sector could
eventually provide some support for equities in the sector.
How have these issues manifested themselves in the current market? Liquidity conditions
have deteriorated considerably. Reflecting these escalating concerns and the Bear Stearns
news, financials have materially underperformed. Bank and broker spreads, in particular,
have been hard hit in recent weeks. Persistent structured credit concerns and macro
hedging continue to weigh on the synthetic market. Against the backdrop of this
extremely weak environment, new issue concessions, and the related repricing of
secondary markets, have increased, further pressuring cash spreads. In tranches, we have
seen mezzanines in particular underperform during the most recent sell-off.
As we look forward, we believe that the Fed will eventually win the liquidity battle.
However, with fundamentals continuing to deteriorate, we expect to move from a
liquidity crisis to more fundamental solvency concerns, as many entities remain
overleveraged. We thus expect the deleveraging to continue.
As a result, we remain concerned that there is further near-term downside. However, in
the context of an increasingly aggressive regulatory response, we believe the market is
likely nearing an inflection point. In our 2008 outlook, we stated that we believed 2008
would provide the best buying opportunity in financials in the past decade. While we do
not think we are there yet, we expect that this buying opportunity is not far off.
In other parts of the market, the roll process is ongoing. Results came in largely as
expected, with the notable caveat that Countrywide Home Loans, Inc will be exiting
CDX IG due to the announced acquisition by Bank of America (one of the dealer firms).
Further information on the specific constituent changes follows later in this report. For
more details with respect to our views on the roll, please see last weeks article.
The steady and reliable CLO bid was one of the primary drivers behind the substantial
growth in leveraged loan issuance from 2003 to mid-2007. However, ever since last
summer CLOs have become increasingly irrelevant to the new issue loan market. That
said, close to half of the outstanding amount of U.S. institutional leveraged loans are
currently held in CLOs, representing, by far, the largest investor base in these assets. In
this weeks focus piece, we discuss the potential influence of CLOs on secondary trading
in the leveraged loan market.
March 17, 2008
107
The CLO Factor in a (Dis-) stressed Loan Market

Claude Laberge
212-526-5450
claberge@lehman.com
Lorraine Fan
212-526-1929
lfan@lehman.com
Asha F. Pagdiwalla
212-526-3364
asha.pagdiwalla@lehman.com
INFLUENCE TO SWITCH TO SECONDARY LOAN MARKET FROM PRIMARY

The steady and reliable CLO bid was one of the primary drivers (if not the one) behind
the 527% growth in institutional leveraged loan issuance from 2003 to mid-2007
($90 billion in 2003 vs. $284 billion in 1H07 annualized). Historically, tracking the
CLO equity arbitrage was a good technical factor for gauging the potential level of
investor demand for CLOs. However, since last summer CLOs have become increasingly
irrelevant to the new-issue loan market ($24 billion in issuance so far this year, $2 billion
of priced CLOs with new warehouses). In fact, other peripheral aspect of CLOs
warehouse liquidations and fear of market value CLO unwindshave mostly contributed
in widening spreads, in our view.
Yet close to half of the outstanding amount of U.S. institutional leveraged loans are
currently held in CLOs ($265 billion in CLOs 1 vs. $556 billion outstanding loans)
representing, by far, the largest base of these assets. For some lesser-known names, the
percentage can reach even higher levels. As the loan market likely comes under
increasing pressure, the influence of CLOs will likely shift to the secondary market from
the new-issue space.
CLOs generally cannot buy or are discouraged from buying stressed and distressed
assets. However, they control a meaningful portion of the supply of these assets and may
elect to sell under some conditions. Therefore, understanding the unique constraints
facing CLO managers can help guide the appropriate strategy for investors seeking
opportunities in stressed and distressed credits. In this article we address some of these
issues, highlighting the likely behavior of CLO managers when faced with defaulted,
low-priced, or CCCrated assets and covenant relief.
SOME RELEVANT CLO FACTS
Cash flow CLOs are managed, bankruptcy-remote, buy-and-hold vehicles with long-term
funding that ignore the market value of the collateral unless it is distressed. Like most
general statements, this captures the essence of the structure even if it is not entirely true
in some cases. 2
CLOs Have No Forced-selling Provisions
Despite a common misconception, CLO managers are generally under no structural
obligation to sell an assetimmediately or over a certain time frameonce it becomes
defaulted or deeply distressed. However, it will lower the overcollaterization (OC) ratios
once the asset is carried at market value or the recovery value assumed by the rating
agencies because of a default or other conditions, instead of par. The failing of OC or
interest coverage (IC) ratios on a payment date affects various parts of the capital
structure, generally diverting the cash flow away from subordinated tranches to the
benefit of the senior ones.
The outstanding amount is higher if market value CLOs to be restructured into cash flow CLOs are included.
We will ignore market value CLOs from now on because they represent an ever shrinking investor base (probably
less than 5% by now) and that we have addressed their technicals in a previous report.
2
March 17, 2008
108
Do Not Expect CLO Unwinds

In very general terms, a CLO may have to unwind if the par value of the portfolio
(adjusted for cash balance, defaults, etc.) is less than the outstanding notional of the
AAA-rated tranche. Given the large (about 25% or more) subordination of these
tranches, which is further enhanced by the cash flow diversion tests, defaults would have
to be significantly higher for many consecutive years with recoveries significantly lower
than historical levels to reach this point. 3 And since CLOs do not have forced-selling
provisions, the current low-priced loan market has no direct impact on this topic.
Stressed/Distressed Trading Is Governed by Test Performance,
Timing, and Purpose
Although cash flows are only affected by OC and IC ratios, the, trades and reinvestments
are also subject to portfolio tests concerning the rating (WARF, Caa/CCC), spread
(WAS), recovery (WARR), average life (WAL), diversity, and bucket size by asset type.
The rule of thumb is that a trade cannot lead a test to fail if it is already passing, or make
it worse if it is already failing.
Generally speaking, credit risk sales and defaulted sales are allowed at any time subject
to some of the above constraints. After the reinvestment period has ended, proceeds from
credit risk sales can be reinvested at the managers discretion but reinvesting defaulted
sales is not permitted. We believe managers tend to buy assets much less frequently once
the reinvestment period ends and will likely use the principal proceeds to amortize the
senior-most tranche.
ASSUMPTIONS FOR OUR DISCUSSION
The conditions above imply that the optimal solution with respect to stressed and
distressed assets for each CLO is unique. However, given the current status of the
majority of the CLOs, we make the following assumptions for our discussion:
CLOs currently have healthy OC and IC levels and are not expected to feel
significant constraints this year even as defaults creep upwards. They may start to
position themselves more defensively as the year goes on.
There is little rating downgrade pressure on CLO liabilities.
Many CLOs have cheap funding (L+40-60) for the next 10 years and have at least a
couple more years of reinvestment period ahead of them.
THE CLO FACTOR ON DEFAULTED ASSETS

Different Treatment for Full Default vs. Current-Pay Assets
The biggest contribution to OC erosion in CLOs comes from defaults, because these
assets are no longer treated at par in the calculation. Most transactions also make a
further distinction between full default assets and current-pay obligations from bankrupt
issuers, with lighter OC penalty affecting the latter (Figure 1).
March 17, 2008
See AAA CLO Tranches Dynamics & Opportunities for a more detailed discussion
109
Figure 1.
OC Treatment
Classification
Assigned Value for OC Test Calculation
Performing
100%
Full Default
Min (Rating Agency Recovery Assumption, Current Market Value)
Current Pay
Varies: Can be 100%, 85%, Current Market Value, 95% of Current Market
Value, or As Defaulted Asset
(Different transactions choose different options, and the treatment is often a
function of rating and market value. In many cases, an asset is treated as a
default if it is rated Caa3 or below)
Caa/CCC
The excess above a specified threshold is carried at market value (as

discussed in a later section)
Source: Moodys, Lehman Brothers
The rating agencies assign a recovery rate to each asset based on a set of rules specific to
each asset type and rating. For first lien loans, the average assumption often falls within
45%-50%, which is generally lower than the current price of the asset.
CLOs Have Retained a Significant Amount of Their Defaulted Debts
As shown in Figure 2, CLO managers have historically not liquidated their entire
position once an issuer has defaulted and have often opted to retain some debt until the
workout in order to realize higher recoveries. 4 In addition, most of the recent defaulted
loans have remained current-pay, hence there was even less incentive for managers to
sell, especially because they are income producing assets.
CLOs are usually not allowed to buy defaulted assets but may be permitted to participate
in debtor-in-possession (DIP) loans, up to some percentage (5% area) specified in the
indenture.
There May Be More Distressed Selling Once Defaults Increase
Most of the 13 defaults year-to-date, which have raised the 12-month loan default rates to
1.8% (before Legends Gaming defaulted), are relatively small issuers.. The examples in
Figure 3 illustrate that a meaningful portion of the institutional term loans of these
issuers are in the hands of CLOs. We estimate that most CLOs have exposure to at least a
few recent defaults by now.
Figure 2.
Exposure of Sample Defaulted Issuers Now and Near the Time of Default
Issuer
Estimated Exposure of Loans in

Default Date CLOs at the Time of Default ($ mn)
Current Exposure of Loans in Current Exposure of CLOs

CLOs Including DIP ($ mn)
to DIP/Exit Loans ($ mn)
Calpine Corp
Dec-05
$554
$210
$14
Delphi Corp.
Oct-05
$107
$92
$40
Dura Operating Corp.
Nov-06
$48
$13

* Current exposure of CLOs includes only transactions that held these loans at the time of default.
4
According to Moodys survey of 109 bank loans which defaulted between 1987 and 2006, ultimate recoveries were
5% higher than post-default trading prices on average. However, this difference was an underestimate because the
ultimate recoveries were discounted to the last interest payment date with the instruments original coupon rate.
March 17, 2008
110
Figure 3.
Selected Recent Defaults Present in CLOs

Default
Date
Industry
1st Lien
Bid Price
South Edge*
8-Mar
Real Estate
$63
Leiner Health
8-Mar
Healthcare
$48
Plastech Engineering Products
8-Feb
Automotive
$24
Issuer
Propex
8-Jan
Textile Manufacturing
$69
Wellman
8-Feb
Chemicals
$72
2nd Lien
Bid Price
$12
$28
Estimated
Notional of
Institutional Term
Loans in CLOs
($Million)
120
102
Estimated
Outstanding
Institutional Term
Loans ($Million)
% in
CLOs
225
232
53%
44%
95
365
26%
39
203
19%
83
450
18%
*The estimated outstanding amount of South Edge does not include the delayed draw loan.
Source: Markit Loans, S&P LCD, Lehman Brothers; bid prices as of March 11, 2008
We see three reasons for a potential increase in distressed selling from CLO managers in
the coming years:
1- Erosion of OC cushion will likely make selling defaulted assets trading
significantly above 45%-50% increasingly attractive. For example, the potential
upside of holding a defaulted loan with a current price of $63 and an expected
recovery of $70 will have to be weighed against the likelihood of diverting cash flow
to (increasingly vocal) equity investors upon a breach of an OC test.
2- Small managers may be overwhelmed as a result of capacity constraints.
Between 2004 and 1H07, there was an increasing number of new CLO management
firms. They consisted of traditional loan participants entering the CLO space, and
personnel from existing management firms who set up their own shops. As defaults
rise, we believe the small managers may not have sufficient capacity to handle the
workout process and therefore would be more willing to exit some of their distressed
positions early.
3- LCDX auction may provide selling opportunities. To the extent that a defaulted
credit is also present in the LCDX index (or is a liquid LCDS name), there is the
potential for a rally because of the perceived short-squeeze pressure ahead of the
auction (see Movie Gallery in Figure 4), despite the fact that the standard practice is
to use cash settlement unless physical settlement is requested. 5 Over time, and if this
becomes a regular pattern, we may see more selling into the rally from CLOs than in
the past for such credits, as the more limited potential upside of realizing ultimate
recovery is weighed against the cost of holding a non-income generating asset in a
cash flow structure.
March 17, 2008
Refer to The LCDS Market Two Years Later, Credit Markets Weekly, November 8, 2008.
111
Figure 4.
Price Trends of Movie Gallery First Lien Loan and

Lehman Brothers High Yield Performing Loan Index
$
105
100
95
90
85
80
75
70
LCDS Auction Settlement
65
60
08-Mar-07
23-May-07
07-Aug-07
22-Oct-07
06-Jan-08
Movie Gallery 1st Lien Loan - Bid Price

Lehman Brothers High Yield Performing Loan Index - Price
Source: Markit Loans, Lehman Brothers
THE CLO FACTOR ON STRESSED ASSETS

Stressed Credits Seeking Covenants Relief
Companies are increasingly seeking covenants relief on their loans, particularly with
respect to the leverage and sometimes for interest coverage and fixed-charge ratios in the
face of declining EBITDA because of the economic slowdown. Waivers and
amendments typically come in the form of one-time fees, higher spreads, or a
combination of both and represent one of the unique features of loans. According to S&P
they contributed 4.5% of the annual total return in 2001-2002.
Unlike banks, CLO managers are not inclined to agree to waivers simply as a means to
maintain relationships with the borrowers. Nevertheless, the CLO structure tends to
create incentives for managers to grant amendments for the following reasons:
1.
Postpone defaults to maintain OC ratios. The structural consideration is

particularly significant if the borrower is fundamentally sound but temporarily
suffering from cyclical or liquidity problems, thus better health and market level
(or recovery if the borrower eventually defaults) are anticipated in the medium
term.
2.
Increase the portfolio spread to improve IC ratios, WAS, and equity payments.
The current nominal spread on S&P/LSTA Leveraged Loan Index is only 252 bp,
as most issuers refinanced in the later stages of the bull market. Despite the
discounted spread being much higher, owing to the low price of loans, this
nominal spread is still very relevant for a variety of tests such as IC ratios and
WAS as well as actual cash flow distributions to equity investors. 6
3.
Less sensitive than other investors to potential price drop following

amendments, as long as the asset remains performing.
In Figure 5, we look at possible issuers that may seek covenant relief in the foreseeable
future, in our view, and the percentage held by CLOs.
6
March 17, 2008
See CLOs in a Low-LIBOR, Low-Priced Loan Market for more discussions.
112
Figure 5.
CLO Exposure to Possible Issuers that May Seek Covenant Relief in the Foreseeable Future
Estimated Notional of
Institutional Term Loans in
CLOs ($Million)
Estimated Outstanding
Institutional Term Loans
($Million)
% in CLOs
Number of CLO
Managers with
Exposure
Top 5 CLO
Manager Exposure
to Total Issuer TL
Neff
70
290
Solo Cup
133
602
24%
> 50
12%
22%
20 - 50
1,624
12%
6,842
24%
> 50
Claire's Stores
9%
276
1,446
19%
20 - 50
7%
Realogy
667
3,129
21%
> 50
7%
Michael Stores
759
2,332
33%
20 - 50
7%
RH Donnelley
630
3,699
17%
> 50
5%
Georgia Pacific
5%
Issuer
Tribune
2,300
7,978
29%
< 20
Rite Aid
46
1,105
4%
< 20
3%
Masonite
44
1,145
4%
< 20
3%
1.
2.
3.

Total outstanding notional for Tribune does not include the $2.1 billion Phase 2 loans as they have not yet been syndicated
Total outstanding notional for R.H Donnelley includes loans of R.H. Donnelly and its subsidiaries Dex Media West and Dex Media East
Total outstanding notional for Rite Aid includes only tranche 2 loans as CLOs do not have any exposure to the Tranche 1 loans
Triple-C Rated Assets

Most, if not all CLOs have so-called triple-C buckets that limit the percentage of assets
rated at or below Caa1 or CCC+ by either Moodys and/or S&P (non-rated assets are
often included as well). Once this limitgenerally set at 5%-10% of the portfolio
notional depending on the transactionis reached, the excess triple-C assets notional is
treated at a discount to par (the triple-C haircut) for OC calculation purpose. This
serves as an early-warning way to create par erosion and divert cash flows ahead of
impending defaults. We believe that many transactions make few CCC purchases, and
therefore this bucket usually fills from normal rating migrations in the portfolio.
In our 2008 Outlook, we analyzed the potential effects of the CCC haircuts on a typical
CLO using the rating migration of the 1998-2003 loan cohort (the worst on record). The
results, presented in Figure 6, show that OC erosion is likely to remain muted over a
three-year horizon but that managers may have incentive to trim their CCC bucket by the
end of the year.
Figure 6.
OC Effect in the Worst Cohort since 1998

Worst-Case CCC Migration
CCC in CLO
collateral
(%)
12%
OC Impact (%)
2%
10%
8%
Max. Allow ed CCC = 7.5%
6%
1%
4%
2%
0%
0%
Now
1 Year
2 Year
3 Year
Cohort
% CCC in Portfolio
CCC Excess
OC Impact from CCC Excess
Source: Lehman Brothers, Moodys, indentures and trustee reports
March 17, 2008
113
It may make sense for the manager to sell triple-C assets once the bucket is above
its limit, as long as the loan trades significantly above its haircut. This is especially true
if the pressure on OC ratios outweighs the loss of higher-spread generating assets.
Low-Priced Loans
In general, the simultaneous sale and purchase of loans at similar prices (and notional)
will have little net effect on the OC ratios. If the price is below par, the reduction in OC
from the discounted sale is matched by the gain from the discounted purchase.
The current low-priced environment for loans creates a new trading dynamics within a
CLO structure: discounted assets purchased below a certain price threshold (usually
$80-$85) no longer count at par for OC calculation purposes, but are rather carried at
their purchased price. This creates an asymmetry between selling and buying at these
levels: the discounted purchase does not compensate the loss in OC from the distressed
sale. Because buying below these levels is unattractive in general, managers are likely to
concentrate in the higher-priced part of the loan market when buying assets.
Even if the manager buys low-priced loans, they are relatively immune from price
deterioration. We note that the purchase price is the only relevant factor when setting the
discount. It is not adjusted for current market price even if the loan trades substantially
lower (or higher) in subsequent monthsalthough they regain their par status if they
trade above $90 for 30 consecutive business days.
UNDERSTANDING STRUCTURAL CONSIDERATIONS
AND MANAGER MINDSET
The primary motives of a CLO manager may sometime appear non-intuitive to investors
more familiar with hedge funds and traditional total-return-based money managers,
especially when it comes to stressed and distressed credits. In this article, we have
focused on the structural considerations, but the broad guidelines presented may give an
overly simplistic account of a very fragmented investor base; there are after all more than
150 CLO managers in the U.S. alone. Some managers are known to be more
conservative, while others may have co-invested in the equity and prefer to be more
aggressive at times. In the recent past, there has also been a growing concentration of
equity investors, and the origination of some transactions is driven by these investors,
resulting in greater influence from equity on the structures and managers. We also point
out that many small managers may become overwhelmed by the distressed assets owing
to pressure of limited resources. 7 Moreover, in many instances, the CLO is managed by a
hedge fund that may have an agenda concerning a certain credit that is not optimal for
the CLO structure, in our view. Yet we expect that over time the CLO factors
surrounding a particular stressed or distressed credit will become an increasingly
important part of implementing the appropriate trading strategy.
March 17, 2008
Refer to CLO Manager Landscape in 2008: From Growth to Consolidation.
114
Global Fixed-Income Data & Calendar

MARKET DATA FROM LEHMANLIVE.COM
Lehman Brothers Bond Index Returns
To access statistics for the following indices, please click here.
Multiverse Index
Global Aggregate
Global High Yield
U.S. Aggregate
Pan-European Aggregate
Asian-Pacific Aggregate
Hedge Fund Indices
Commodity Index
Convertibles Index
Monetary Policy Decisions
U.S. Credit Origination
Monetary Policy Watch
Central Bank Meeting Calendar
Credit Market Statistics
U.S. Ratings Changes
Lehman Brothers Historical Market Data via Time Series Plotter

To access historical market data via the Time Series Plotter for the following series, please click here.
U.S. Treasury Implied Vol
U.S. TED Spreads
Implied Swaption Vol
U.S. Treasury Yield Spreads
LIBOR Vol
German Swap Spreads
U.S. Agency Spreads
U.S. Swap Spread Vol
Japan Swap Spreads
U.K. Swap Spreads
U.S. Swap Spreads
Lehman Vol Indices
Map of Fixed-Income Market
U.S. Universal
European Governments
U.S. Corporate
European Corporates
U.S. High Yield
Market Monitors
Liquid Markets
Credit
Securitized
U.S. Governments
U.S. Credit
U.S. MBS
European Governments
European Credit
U.S. ABS
U.S. Derivatives
U.S. CMBS
European Derivatives
European Structured Finance
U.S. Agencies
March 17, 2008
115
UPCOMING ECONOMIC DATA RELEASES

TKY
LDN
NY
(Tokyo, London and New York time)
Period
Prev 2
Prev 1
Latest
Lehman
Consensus
Monday 17 March
8.50
Japan
Tertiary Industry Index, sa, %m-o-m
Jan
1.2
0.0
-0.6
1.7
0.7
8.50
Japan
Revised Leading diffusion index, %
Jan
16.7
16.7
30.0
n.a.
n.a.
n.a.
8.50
Japan
Revised Coincident diffusion index, %
Jan
63.6
27.3
22.2
n.a.
14.00
5.00
1.00
Singapore
Non-oil domestic exports, % y-o-y
Feb
-3.4
-4.5
2.8
6.7
9.4
17.15
8.15
4.15
Switzerland
Retail sales volumes, % y-o-y, sa
Jan
2.2
2.9
1.2
n.a
2.7
Egypt
Trade balance (USD bn)
Jan
-1088.3
-1013.6
-1070.9
n.a.
n.a.
22.00
13.00
9.00
Poland
Wage growth (%, y-o-y, gross)
Feb
12.0
7.2
11.5
n.a.
11.7
17.00
8.00
4.00
Turkey
Unemployment (%)
Dec
9.3
9.7
10.1
n.a.
n.a.
21.30
12.30
8.30
US
Current account balance, $bn
Q4
-197.1
-188.9
-178.5
-181.3
-184.9
21.30
12.30
8.30
US
Empire State survey
Mar
9.8
9.0
-11.7
-9.0
-6.3
22.00
13.00
9.00
US
Net international capital flows, $bn
Jan
89.7
150.8
60.4
75.0
n.a.
22.15
13.15
9.15
US
Industrial production, %m-o-m
Feb
0.4
0.1
0.1
-0.3
-0.1
81.3
22.15
13.15
9.15
US
Capacity utilization, %
Feb
81.5
81.5
81.5
81.4
17.00
13.00
US
NAHB homebuilder sentiment index
Mar
18
19
20
20
20
21.30
12.30
8.30
Canada
Manufacturing shipments, %m-o-m
Jan
-0.3
1.0
-3.4
0.0
0.0
21.30
12.30
8.30
Canada
New motor vehicle sales, %m-o-m
Jan
-2.0
-2.7
4.8
5.0
6.0
Feb
8.5
-2.2
6.9
3.0
n.a.
Tuesday 18 March
6.00
S. Korea
Department store sales, % y-o-y
9.00
Australia
Reserve bank of published board minutes
17.15
8.15
4.15
Hong Kong
Unemployment rate, % sa
Feb
3.6
3.4
3.4
3.4
3.4
18.30
9.30
5.30
UK
Targeted CPI, % m-o-m, nsa
Feb
0.3
0.6
-0.7
0.6
0.8
18.30
9.30
5.30
UK
Targeted CPI, % y-o-y, nsa
Feb
2.1
2.1
2.2
2.4
2.5
18.30
9.30
5.30
UK
RPI (all items), % m-o-m, nsa
Feb
0.4
0.6
-0.5
0.7
0.8
18.30
9.30
5.30
UK
RPI (all items), % y-o-y, nsa
Feb
4.3
4.0
4.1
4.0
4.2
18.30
9.30
5.30
UK
RPIX (exc. mortgage costs), % m-o-m, nsa
Feb
0.4
0.5
-0.4
0.8
n.a.
18.30
9.30
5.30
UK
RPIX (exc. mortgage costs), % y-o-y, nsa
Feb
3.2
3.1
3.4
3.6
3.7
18.30
9.30
5.30
UK
CPI ex-energy, food, alc. and tob., % y-o-y, nsa
Feb
1.4
1.4
1.3
1.2
1.4
17.15
8.15
4.15
Switzerland
Industrial production, % q-o-q, sa
Q4
-4.7
7.0
0.0
n.a
n.a
17.15
8.15
4.15
Switzerland
Industrial production, % y-o-y, sa
Q4
7.3
10.3
10.7
n.a
8.2
17.00
8.00
4.00
Czech Rep'
Retail sales (% y-o-y)
Jan
9.4
5.9
5.4
n.a.
4.4
21.30
12.30
8.30
US
PPI, %m-o-m
Feb
2.6
-0.3
1.0
0.5
0.4
21.30
12.30
8.30
US
PPI, %y-o-y
Feb
7.6
6.5
7.7
6.9
6.8
21.30
12.30
8.30
US
Core PPI, %m-o-m
Feb
0.3
0.2
0.4
0.2
0.2
21.30
12.30
8.30
US
Core PPI, %y-o-y
Feb
1.9
2.1
2.4
2.1
2.1
21.30
12.30
8.30
US
Housing starts, m, saar
Feb
1.178
1.004
1.012
0.970
0.995
21.30
12.30
8.30
US
Housing starts, %m-o-m
Feb
-7.5
-14.8
0.8
-4.2
-1.7
21.30
12.30
8.30
US
Building permits, m, saar
Feb
1.162
1.080
1.061
1.030
1.020
21.30
12.30
8.30
US
Building permits, %m-o-m
Feb
-0.7
-7.1
18.15
14.15
US
FOMC rate decision, %
21.30
12.30
8.30
Canada
Consumer price index, %m-o-m (nsa)
Feb
0.3
0.1
-0.2
0.3
0.3
21.30
12.30
8.30
Canada
Consumer price index, %y-o-y (nsa)
Feb
2.5
2.4
2.2
1.7
1.8
-3.0
-2.9
-3.9
3.00
2.25
2.50
21.30
12.30
8.30
Canada
Core CPI, %m-o-m (nsa)
Feb
0.0
-0.3
0.1
0.3
0.3
21.30
12.30
8.30
Canada
Core CPI, %y-o-y (nsa)
Feb
1.6
1.5
1.4
1.2
1.2
March 17, 2008
116
TKY
LDN
NY
Period
Prev 2
Prev 1
Latest
Lehman
Consensus
Wednesday 19 March
8.50
9.30
0.30
Japan
All-industry output, sa, % m-o-m
Jan
1.2
-0.5
-0.2
0.0
0.1
Australia
Dwelling starts, % q-o-q, sa
Q4
-0.8
-2.5
1.3
1.5
n.a.
18.00
9.00
5.00
Malaysia
Consumer price index, % y-o-y
Feb
2.3
2.4
2.3
3.0
2.5
18.00
9.00
5.00
Italy
Industrial orders (% m-o-m, sa, wda)
Jan
-1.1
2.9
-5.4
-0.3
1.5
18.00
9.00
5.00
Italy
Industrial orders (% y-o-y, sa, wda)
Jan
5.8
9.1
1.6
4.4
n.a.
19.00
10.00
6.00
Euro area
Trade balance ( bn, nsa)
Jan
5.5
3.0
-4.2
n.a.
-7.0
19.00
10.00
6.00
Euro area
Trade balance ( bn, sa)
Jan
2.2
2.0
-2.1
n.a.
n.a.
18.30
9.30
5.30
UK
MPC minutes published, vote for rates on hold
Mar
0-9
8-1
0-9
8-1
8-1
18.30
9.30
5.30
UK
Average earnings, % y-o-y, sa, 3mma
Jan
4.0
4.0
3.8
3.9
3.8
18.30
9.30
5.30
UK
Average earnings, % y-o-y, sa
Jan
3.7
4.1
3.6
3.8
n.a.
18.30
9.30
5.30
UK
Average earnings ex-bonuses, % y-o-y, sa
Jan
3.5
3.7
3.8
3.9
n.a.
18.30
9.30
5.30
UK
Claimant unemployment, % of labour force, sa
Feb
2.5
2.5
2.5
2.5
2.5
18.30
9.30
5.30
UK
Claimant unemployment, ch, m-o-m, 1,000s, sa
Feb
-10
-9
-11
-5
-5
18.30
9.30
5.30
UK
LFS, unemployment rate, %, 3mma
Jan
5.3
5.3
5.2
5.2
5.2
18.30
9.30
5.30
UK
LFS employment, ch, 3m-o-3m, 1,000s, sa
Jan
113
174
175
120
n.a.
20.00
11.00
7.00
UK
CBI Monthly Trends survey, output, %
Mar
11
10
n.a.
20.00
11.00
7.00
UK
CBI Monthly Trends survey, orders, %
Mar
n.a.
20.00
11.00
7.00
UK
CBI Monthly Trends survey, prices, %
Mar
15
21
22
25
n.a.
17.00
8.00
4.00
Hungary
Wage growth (%, y-o-y, gross)
Jan
8.6
9.3
4.3
n.a.
n.a.
18.00
9.00
5.00
Iceland
Wage index (% y-o-y)
Feb
8.3
8.6
6.2
n.a.
n.a.
22.00
13.00
9.00
Poland
PPI (% y-o-y)
Feb
2.3
2.8
3.2
n.a.
3.2
22.00
13.00
9.00
Poland
Industrial output (% y-o-y)
Feb
8.5
6.4
10.8
n.a.
12.0
18.00
9.00
5.00
South Africa Quarterly bulletin (inc Expenditure GDP)
18.00
9.00
5.00
South Africa Current account (% GDP)
Q4
-6.9
-6.5
-8.1
-7.5
n.a.
18.00
9.00
5.00
South Africa Retail sales (% y-o-y)
Feb
2.0
-0.2
-0.5
-1.5
-0.6
17.00
13.00
Turkey
TCMB rate decision (%, policy rate)
20.00
11.00
7.00
US
Mortgage applications, %w-o-w
Mar
15.75
15.50
15.25
15.25
n.a.
14-Mar
-22.6
-19.2
3.0
n.a.
n.a.
Thursday 20 March
Japan
Japan - National holiday
15.30
6.30
2.30
India
Wholesale price index, % y-o-y
8-Mar
4.9
5.0
5.1
5.0
n.a.
17.15
8.15
4.15
Hong Kong
Consumer price index, % y-o-y
Feb
3.4
3.8
3.3
5.2
4.8
16.00
7.00
3.00
Germany
Producer prices (% m-o-m, nsa)
Feb
0.8
-0.1
0.8
0.5
0.3
16.00
7.00
3.00
Germany
Producer prices (% y-o-y, nsa)
Feb
2.5
2.5
3.3
3.6
3.4
17.00
8.00
4.00
France
Flash Manufacturing PMI (activity, index, sa)
Mar
53.8
53.9
53.8
53.1
53.4
17.00
8.00
4.00
France
Flash Service sector PMI (activity, index, sa)
Mar
58.9
56.6
58.2
57.8
57.6
17.30
8.30
4.30
Netherlands
Unemployment rate (%, 3mth avg, sa)
Feb
4.1
4.1
4.1
4.1
4.1
17.30
8.30
4.30
Germany
Mar
53.6
54.4
54.3
53.0
54.0
17.30
8.30
4.30
Germany
Mar
51.2
49.2
52.2
51.9
51.9
18.00
9.00
5.00
Euro area
Mar
52.6
52.8
52.3
51.5
52.0
52.3
18.00
9.00
5.00
Euro area
Mar
53.1
50.6
52.3
52.1
19.00
10.00
6.00
Italy
Unemployment (% of labour force, sa)
Q4
6.2
6.0
5.9
5.9
5.9
19.00
10.00
6.00
Italy
Employment (% y-o-y, sa)
Q4
0.7
0.7
1.7
1.5
n.a.
18.30
9.30
5.30
UK
Retail sales volumes, % m-o-m, sa
Feb
0.4
-0.3
0.9
-0.3
-0.2
18.30
9.30
5.30
UK
Retail sales volumes, % 3m-o-3m, sa
Feb
1.0
0.5
0.6
0.4
n.a.
18.30
9.30
5.30
UK
Retail sales volumes, % y-o-y, sa
Feb
4.2
2.9
5.7
3.5
3.6
18.30
9.30
5.30
UK
Broad money (M4), % m-o-m, sa
Feb
0.4
1.5
1.4
1.1
0.9
18.30
9.30
5.30
UK
Broad money (M4), % y-o-y, sa
Feb
11.9
12.5
13.1
13.3
12.8
18.30
9.30
5.30
UK
M4 lending, bn, sa
Feb
16.4
18.3
21.8
20.7
17.0
18.30
9.30
5.30
UK
PSNB, bn, nsa
Feb
10.5
6.9
-14.1
2.4
2.5
18.30
9.30
5.30
UK
PSNB, bn, nsa, year to date
Feb
33.7
40.7
26.5
28.9
n.a.
18.30
9.30
5.30
UK
PSNCR, bn, nsa
Feb
9.0
16.0
-22.1
3.1
2.5
18.30
9.30
5.30
UK
PSNCR, bn, nsa, year to date
Feb
17.4
33.4
11.3
14.4
n.a.
0.3
17.15
8.15
4.15
Switzerland
Producer & import prices, % m-o-m, nsa
Feb
0.3
-0.1
0.5
n.a
17.15
8.15
4.15
Switzerland
Producer & import prices, % y-o-y, nsa
Feb
3.0
3.0
3.7
n.a
3.7
Egypt
CBE rate decision (%, deposit rate)
Mar
8.75
8.75
9.00
n.a.
n.a.
21.30
12.30
8.30
US
Initial jobless claims, 000
15-Mar
374
353
353
355
n.a.
21.30
12.30
8.30
US
Continuing jobless claims, m
8-Mar
2.802
2.828
2.835
2.840
n.a.
23.00
14.00
10.00
US
Philadelphia Fed survey
Mar
-1.6
-20.9
-24.0
-19.0
-18.0
23.00
14.00
10.00
US
Leading indicators, %m-o-m
Feb
-0.4
-0.1
-0.1
-0.3
-0.3
21.30
12.30
8.30
Canada
Composite leading indicators, %m-o-m
Feb
-0.1
0.0
0.2
0.0
0.1
March 17, 2008
117
TKY
LDN
NY
Period
Prev 2
Prev 1
Latest
Lehman
Consensus
Friday 21 March
8.00
S. Korea
Real GDP (sa), % q-o-q
Q4 F
0.9
1.8
1.3
1.5
n.a.
8.00
S. Korea
Real GDP, % y-o-y
Q4 F
4.0
5.0
5.2
5.5
n.a.
17.00
8.00
4.00
Taiwan
Unemployment rate, % sa
Feb
4.0
3.9
4.0
4.0
4.0
16.45
7.45
3.45
France
Household consumption (% m-o-m, sa)
Feb
0.1
2.1
-1.2
0.3
0.4
16.45
7.45
3.45
France
Household consumption (% y-o-y, sa)
Feb
2.6
4.0
2.4
2.8
n.a.
16.45
7.45
3.45
France
Household consumption (ex autos) (% m-o-m, sa)
Feb
-0.1
1.5
0.2
-0.2
n.a.
16.45
7.45
3.45
France
Household consumption (ex autos) (% y-o-y, sa)
Feb
2.0
2.9
2.6
2.6
n.a.
17.30
8.30
4.30
Italy
Consumer confidence (index, sa)
Mar
106.9
102.2
103.0
103.0
102.4
18.00
9.00
5.00
Italy
Retail sales (% m-o-m, value, sa)
Jan
0.3
-0.3
0.1
0.3
0.1
18.00
9.00
5.00
Italy
Retail sales (% y-o-y, value, sa)
Jan
1.0
0.2
0.3
0.9
n.a.
UK
Bank Holiday - Good Friday
17.00
8.00
4.00
Hungary
Retail sales (% y-o-y)
Jan
-4.1
-4.2
-4.0
n.a.
-4.1
22.00
13.00
9.00
Poland
Net core inflation (% y-o-y)
Feb
1.5
1.7
n.a.
n.a.
n.a.
US
Good Friday Holiday - Markets Closed
Source: Lehman Brothers Global Economics.
March 17, 2008
118
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FIXED INCOME RESEARCH | MONDAY, MARCH 17, 2008

A Time for Calm

The market overshoot/risk paranoia in the

In the current environment, good news

The Fed is taking steps to improve market

the risks of a sudden and sharp drop in

Global infrastructure investment is being

Investors often view commodities as

The deterioration in financial markets

INTEREST RATES STRATEGY

The Feds next steps, besides easing, are

Last week was another turbulent,

We believe that the Fed will eventually

A Time for Calm .............................. 8

Can Someone Hit the Brakes? ......77

Ongoing Risk Aversion

INTEREST RATES STRATEGY

Liquidity Lesson ............................ 20

U.S. Interest Rates Strategy

Liquidity Concerns and

How Deep Are

HEL: Subprime Performance in

The Week Ahead .......................... 25

ABX: Update on the February

European Interest Rates Strategy

ABX: Relative Value Views

Its Always Fair Weather ................62

Consumer ABS: Auto, Credit Cards,

Euro Relative Value:

Street-Fighting Man ...................... 22

Re-coupling with Decoupling ........ 28

Weekly Review: Fed Actions/S&P

Australia: Mind the Gap ................ 34

Market Monitor ..............................92

Euro Area Inflation Strategy:

CMBX Update ...............................98

Asian Interest Rates Strategy

Trade Idea in Index Swaps............96

European Structured Products

Lehman Brothers | Global Relative Value

Global Fixed-Income Asset Allocation

Tracking Error Volatility

Global Aggregate Portfolio

Global Aggregate Index by Currency of Issuer

Global Aggregate Index

Global Aggregate Portfolio

Asia-Pacific Aggregate Index

Asian-Pacific Aggregate Portfolio

March 17, 2008

Asian-Pacific Aggregate Index by Currency of Issuer

Lehman Brothers | Global Relative Value

U.S. Fixed-Income Asset Allocation

U.S. Aggregate Core Portfolio

Recommended Portfolio by Duration Range

Portfolio Allocation by Asset Class

Contribution to Spread Duration

Contribution to OAD by Asset Class

Contribution to Spread Duration by Asset Class

March 17, 2008

Lehman Brothers | Global Relative Value

U.S. Fixed-Income Asset Allocation

U.S. Aggregate Core Portfolio

T-Bills/ 0-1 yr 2 yr/ 1-2 yr

Percent of Market Value