Ireland:

Blurring the Lines between Banking & Sovereign Risk

Assessing the Implications of Sovereign Crisis 2.0 on U.S. Capital Markets

November 2010

Tom Joyce Javier Guzman

Debt Capital Markets Strategy Debt Capital Markets Strategy
((212)) 250 - 8754 ((212)) 250 - 3464
tom.joyce@db.com javier.guzman@db.com

Deutsche Bank Securities Inc., a subsidiary of Deutsche Bank AG, conducts investment banking and securities activities
in the United States.
 “Irish banks will become significantly smaller than they have in the past, so that they can
gradually be brought to stand on their own two feet once more.
more ”
~ Brian Cowen, Irish Prime Minister (Nov 21, 2010)

“We have to fund ourselves as a state with senior debt. And other banks have to fund
themselves with senior debt. You cannot send out a message in an economy like Ireland that
senior debt can be dishonored. We're far too dependent on international investment."
~ Brian Lenihan, Irish Finance Minister (Sept 29, 2010)

“There may be a contradiction between the interests of the financial world and the interests of
the political world. We cannot keep explaining to our voters and our citizens why the taxpayer
should bear the cost of certain risks and not those people who have earned a lot of money
from taking those risks.” ~ Angela Merkel, German Chancellor (Nov 11, 2010)

"Investors must share the cost of sovereign debt restructuring. All stake holders must
participate in the gains and losses of any particular situation.”
~ Christine Lagarde, French Finance Minister (Nov 10, 2010)

“What is better than to sit at the end of the day and drink wine with friends, or substitutes for
friends.” ~ James Joyce, Irish author (1882 – 1941)

2
Contents

1. Introduction

2. The “Irish Crisis”

A. The Banking System

B. The Sovereign

3. Potential Solutions

4. Potential U.S. Capital Markets Implications

I t d ti
Introduction
Section 1
 Key Considerations in Sovereign Risk Analysis
Too often, sovereign
risk analysis focuses Key Factors Critical Questions
narrowly on the
absolute amount of
government debt, and
Total public sector debt • Size vis-à-vis the economy? Trajectory?
the liquidity profile of
g
the sovereign Total private sector debt • Distribution across financial sector, corporate sector, and
at the consumer level?
However, a number of
Debt ownership profile • Foreign ownership percentage? Investor profile?
other critical factors
must also be
considered Dependence on capital • Reliance on international capital markets? Liquidity?
markets / liquidity
q ypprofile • Size and strength
g of domestic bond market,, if any?
y
“Confidence” with investors • Reputation issues, if any, on quality of data?
Ireland performs • Historical track record with key government statistics?
very strongly on
some of these
Ability to devalue currency • Extent of power over own currency?
metrics ((liquidity,
q y,
competitiveness of Reserve currency status • Is the sovereign a significant global reserve currency?
the economy)… • Are their technical reasons for strong demand even if
fundamentals have some weaknesses?
…and less so on
others (dependence Competitiveness of the • Flexibility and competitiveness? Structural issues?
on international economy • Ability of economy to grow from under high debt levels?
capital markets, Ability to deliver on fiscal • Social stability and strength of political institutions?
strength of banking
austerity programs • Strength and will of government coalition?
system)
Strength of banking system • Transparency? Funding access?
• Capitalization? Liquidity?
Assumption of bank sector • Size and timing of sovereign exposure to bank liabilities?
liabilities by Government • Transparency of the exposure?
 Understanding the Irish Sovereign Crisis
Ireland’s
Ireland s banking Bankingg Crisis Sovereign
g Crisis Potential Solutions
crisis and (6 Key Issues) (5 Key Issues) (5 Key Steps)
sovereign crisis
have effectively
1. The Irish banking 1. 2010 fiscal deficit of 32% 1. EUR 80-90 billion from
system is too big (12.9% not including bank the EFSF/IMF/EFSM
converged,
rescues) (subject to change)
making the two
virtually 2 Sharp
2. Sh assett and
d credit
dit 2 2010 gross debt / GDP of
2. 2 A
2. Acceleration
l ti off fiscal
fi l
indistinguishable 94% (~70% on net basis) adjustment program
quality deterioration
Whereas Greece’s
sovereign crisis 3. Significant government 3. Strained access to capital 3. Continued ECB support
was driven by an capital injections markets (bond purchases and bank
oversized (EUR 45 billion) li idit )
liquidity)
Government
sector (and a 4. Significant bank 4. Contagion to Portugal, 4. Clarity on the EU’s
liquidity crisis), liability guarantees Spain and Italy planned “Orderly
the heart of (EUR 147 billion) Restructuring Mechanism”
Ireland’s
5 Ireland
5. Ireland’s
s “bad
bad bank
bank” 5 Contagion to European
5. 5. Growth from Ireland’s
Ireland s
sovereigni debt
d bt
crisis is more policy (NAMA) financial system competitive economy
closely linked to crystallized losses
the State’s
6. Exceptionally high
decision to
directly assume 700
dependence on Central
significant 600 Bank funding
financial sector
liabilities 500 10 Year Irish Government Bond Spreads to Germany
400 2008 2009 2009 2010
bps

300

200

Source: Bloomberg 100

0
Jan‐08 Mar‐08 May‐08 Jul‐08 Sep‐08 Nov‐08 Jan‐09 Mar‐09 May‐09 Jul‐09 Sep‐09 Nov‐09 Jan‐10 Mar‐10 May‐10 Jul‐10 Sep‐10 Nov‐10
 Escalation of the “Irish Crisis” Since October 29
The ebb and flow of Irish Government Bond Yields (October 29
29, 2010 – Present)
public discussion
among European 2yr Yield 4yr Yield 10yr Yield
leaders since Peak: November 11
October 29 9
regarding the
possibility of
potential losses for 8
bondholders has
been a primary October 29
driver of the
7
widening in Irish
G
Government t bond
b d
yields
6
%

Uncertainty as to
the likelihood and
timing of an EFSF 5
bailout has also
been a critical
factor 4

3
1‐Oct

4‐Oct

7‐Oct

10‐Oct

13‐Oct

16‐Oct

19‐Oct

22‐Oct

25‐Oct

28‐Oct

31‐Oct

3‐Nov

6‐Nov

9‐Nov

12‐Nov

15‐Nov
October 29, 2010
 European Union leaders endorse idea of linking bondholder losses to future bailouts

November 12, 2010

 EU leaders forced to clarify at G-20 meetings that “existing” bondholders will be protected
7
Source: Bloomberg
 Escalation of the “Irish Crisis” Since October 29
Dates Details
The Irish crisis has
escalated rapidly October 29  German Chancellor Angela Markel proposes “orderly restructuring” mechanism
since October 29, requiring bond holders to take haircuts in the event of a sovereign crisis
when German – Investors immediately responded by re-pricing sovereign default risk
Chancellor Merkel
and French November 4  Irish Finance Minister Brian Lenihan announces changes to allocate EUR 6 bn of
President Sarkozy y the 4-year
4 year EUR 15 bn fiscal plan to 2011
endorsed the
possibility of bond November 9  German Finance Minister Wolfgang Schaueble discloses some detail on
holder losses on Germany’s 2-tier orderly resolution crisis mechanism (with bondholder losses)
future bailouts
November 10  French Finance Minister Christine Lagarde publicly supports Germany’s proposal
Their position was for an orderly resolution crisis mechanism (with bondholder losses)
later clarified on  Ireland’s bank liability guarantee program (ELG) extended to June 2011
November 12th
November 11  Clearinghouse LCH Clearnet increases margin requirements for customers
Key Market Dates trading Irish bonds (raised again in following week)
 Irish sovereign
g debt markets spike.
p The 10 yyear yyield reaches record levels of 9%
Oct. 29 / Nov. 11: and Irish CDS widens above 700 bps
Record sell-off in
Irish bonds and November 12  Joint statement by France, Germany, Italy, Spain, and UK at G-20 Summit
CDS confirming that “orderly restructuring” will not require “existing” bond holder
haircuts for debt issued prior to 2013 (investor concerns eased)
Nov 12: Strong
Nov.
rally as worries over
restructuring plan November 16  Sharp global sell-off across risk asset classes as Ireland refuses initial EU/ IMF/
dissipate ECB bailout efforts at EU Finance Minister meetings in Brussels
– Declines in global equities, HY bonds, commodities, and currencies
Nov. 16: Global
November 21  Ireland finally
y agrees
g to accept
p bailout from EU and IMF ((details to be negotiated
g
market sell-off
sell off as
in subsequent weeks)
Ireland initially
refuses bailout

8
 Assessing the “Magnitude” of Ireland
Key Facts on Ireland (As of Nov 2010) Relative Economy Size

 Population: 4.6 million Country % of Euro ‐ 16 % of Euro ‐ 27

Germany 27.4% 20.5%
France 21.2% 15.9%
 GDP: EUR 156.1 billion Italy 16.9% 12.6%
Spain 11.4% 8.5%
Netherlands 6.4% 4.8%
 GDP per capita: EUR 34,907 Belgium 3.8% 2.9%
Austria 3.0% 2.3%
 Ireland % of EU GDP: 1.3%
1 3% Greece 2.5% 1.9%
Finland 1.9% 1.4%
Portugal 1.9% 1.4%
 Sovereign debt outstanding: EUR 146.2 billion Ireland 1.7% 1.3%
Slovakia 0.7% 0.5%
Luxembourgg 0.4% 0.3%
 T 6 banks
Top b k total
t t l assets:
t ~ EUR 520 billi
billion Slovenia 0.4% 0.3%
Cyprus 0.2% 0.1%
 Top 6 banks total assets / GDP: ~ 3.33x Malta 0.1% 0.0%
UK NA 14.0%
Sweden NA 2.8%
 Total bank bailout (Nov 2010): ~ EUR 45 billion Poland NA 2.7%
Denmark NA 1.9%
Czech Republic NA 1.2%
 Bank liability guarantees (Nov 2010): ~ EUR 147 billion Romania NA 1.0%
Hungary NA 0.8%
Bulgaria NA 0.3%
 Assets transferred to NAMA (“bad bank”): EUR 53 billion (nominal)
Lithuania NA 0.2%
Latvia NA 0.1%
Estonia NA 0.1%
9
Source: Irish Central Bank. Deutsche Bank Global Markets Research, IMF (October 2010) , Bloomberg, Irish Times (October 2010). EuroStat.
 Reason for Optimism: Ireland’s Competitive Economy
Reasons for Optimism on Ireland’s
Ireland s Recovery
With a properly
structured bank Consideration Description
sector bailout,
Ireland’s economy
offers a number of
Fiscal adjustment • Proven track record: Ireland moved early on its fiscal adjustment (began
compelling reasons track record nearly 2 years ago); bodes well for forthcoming EUR 16 billion adjustment
to be optimistic Bank sector loan • On target to have removed EUR 73 billion of bad loans from bank balance
about its fiscal clean-up sheets via NAMA; only EU country to have moved early on such an initiative
turnaround
Political / social • Though current coalition Government has narrow majority, Ireland has strong
Ireland’s economy stability and stable political institutions
grew annually
g y at a • Has also had strong social cohesion and acceptance of fiscal cuts to date
rate of 6.5% from
1990 to 2007… Highly educated & • Youngest labor force in Europe (36% under age 25); English-speaking
flexible workforce • Education system ranks 7th globally for higher education
…and the economy • Education expenditures over last 10 years increased 10% per year on
doubled in size average, versus 3% in EU
during the decade • Higher labor productivity vs GDP per person than Germany
Germany, UK & Japan
ending 2006
Strong export • EUR 39 billion balance of trade surplus in 2009, and EUR 28 billion as of
Most importantly, engine August 2010
Ireland’s foreign • Highest in EU on a per capita basis
direct investment
(FDI) has held up g Foreign
Strong g • 5x g
greater than the OECD averageg
very well during the Direct Investment • EUR 139 and 169 billion in 2008 and 2009, respectively
crisis • IDA Ireland, agency targeting FDI, says 2010 has been the best in 7 years
Lowest corporate • 12.5% corporate tax rate is lowest among major European economies
tax rates in Europe • 25% R&D tax credit
Strong GDP • Only one of Greece, Portugal and Spain with positive 2011 GDP growth
outlook forecast (DB estimate of +1.2% growth in 2011)

Source: Deutsche Bank Global Markets Research.IMF. IDA Ireland: Vital Statistics (Oct 2010), Central Statistics Office 10
(October 2010). Credit Sights.
 Reasons for Concern: Contagion
Even with a well Key Areas of Concern for Contagion
structured package
for Ireland, the risk
of “contagion” is  How much further can bank sector losses deteriorate?
still the greatest
 Will the country continue to deliver on its strong two year track record for
area of concern in
the global capital fiscal austerity
ypprograms?
g
markets
 Ability to deliver on its fiscal austerity programs?
The  Is the economy competitive enough to eventually grow out from underneath
“fundamentals” of its debt levels?
Greece, Ireland,
P t
Portugal,
l Spain,
S i  Will the term of the EFSF loans be extended if needed?
and Italy are very
different, but  Will Portugal be able to improve upon its comparatively poor track record on
contagion risk is fiscal austerity (vis-à-vis other peripherals in 2010)?
still high
 Is the economy competitive enough to eventually grow out from underneath
it debt
its d bt levels?
l l ? How
H to
t jump-start
j t t largely
l l stalled
t ll d economic
i growth?
th?

Key Market Concern  Potential for bank sector losses to accelerate significantly? Transparency
and market confidence?
In a worst case
scenario,
i are Spain
S i
 Has differentiated itself on fiscal policy direction, but how to jump-start
jump start
and Italy effectively largely stalled economic growth? 20% unemployment?
“too big to fail”?
 Ability to deliver on fiscal austerity programs?
 Ability to continue to tap capital markets in order to meet its massive 2011 –
2012 funding needs?

Source: Deutsche Bank Global Markets Research. 11

 Key Upcoming Dates
A number of key
upcoming events Key Upcoming Dates
will be important to
properly assessing Dates Details
the path ahead
Weeks of Nov 22 / 29  Decisions around current Irish negotiations with EU, IMF and ECB?

November 25  Irish bi-Elections (Donegal)

November 30  Deadline for the approval of the Portuguese 2011 budget

December 2  EU Council Meetings: ECB decisions on liquidity regime expected

December 7  Irish budget meetings

 Failure to approve the budget would effectively result in a “no confidence” vote in
the Government, and could force a national election

Dec. 16 – 17  EU Council Meetings: Draft text for the orderly restructuring mechanism due (critical
focus area for international bondholders)

December 23  Last ECB 6-month and 12-month LTRO’s expire

December 28  Final ECB weekly MRO tender of the year

January 12, 2011  Portuguese presidential election

2011  EU regulators plan to repeat the EU bank stress tests of July 2010

Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec. 12
Th “Irish
The “I i h Crisis”
Ci i ”
Section 2
Th Banking
The B ki System
S t
Section A
 The Irish Banking Crisis: 6 Key Issues
From a sovereign 6 Key Issues
crisis
perspective, a • The Irish Banking System is Too Big
defining moment Issue # 1
of the Irish crisis, – Top 6 banks assets represent 3.33x GDP
in retrospect,
• Sharp bank asset and credit quality deterioration:
may beb traced
t d to
t Issue # 2
the decision by - Phase 1: Construction and commercial real estate loan losses
the Irish
Government to - Phase 2: Residential mortgage losses
assume
significant • Significant government capital injections into banking system:
Issue # 3
liabilities from an - EUR 45 billion to date
oversized
banking sector - Significantly more expected in EU / IMF bailout underway

• Significant banking sector liability guarantees

Issue # 4
- EUR 147 billion (EUR 116 billion deposits,
deposits EUR 31 billion of bank debt)

• Ireland’s “Bad Bank” policy (NAMA) crystallized losses

Issue # 5
– Ireland is among the few countries to have actually removed “toxic loans”
from the balance sheets of its banking system
– Size of the program (EUR 73 billion) and discounts (~58%) have resulted
in massive bank sector capital injections

Issue # 6 • Exceptionally high dependence on Central Bank funding

– Driven byy deposit
p outflows and limited access to capital
p markets
– Record ECB funding: EUR 130 billion (~30% of all ECB funding)
– Record Irish Central Bank funding: EUR 20 billion of “exceptional
liquidity” extended to Irish banks in Sept and Oct (in addition to ECB funds)
15
 Issue # 1: The Irish Banking System is Too Big
The size of the Key Metrics Size
Irish banking
system relative to Ireland’s GDP EUR 156 billion
its economy has
been a core issue Ireland’s Top 6 Banks Assets ~ EUR 520 billion
in this crisis
Ireland’s Top 6 Banks Assets / GDP ~ 3.33x
3 33x

By contrast, the Estimated Irish Banking System Crisis Losses EUR 85 billion
nearly 8,000
banks in the (Includes Foreign-Owned Banks in Ireland)
United States Estimated
st ated Bank
a Losses
osses / G
GDP ~ 50%
represent approx
0.85x (or 85%) of
U.S. GDP

Bank of Ireland Allied Irish Banks Anglo Irish Bank

Government Aid Received EUR 3.5 bn EUR 3.5 bn EUR 23 bn

Government Stake 36% Over 90% 100% Nationalized

(currently 18% but set to rise)

“The banks were too big a problem for the country. I accept that.”

~ Brian Lenihan, Irish Finance Minister (on Nov 19, 2010)

Note: Ireland’s 6 largest banks used as a proxy for the Irish banking system (Allied Irish Banks, Bank of Ireland,
Anglo Irish, Permanent TSB, Irish Nationwide and Ulster Bank). Life insurance assets not included.
16
Source: Central Bank of Ireland.
 Issue # 2: Asset and Credit Quality Deterioration
2 Phase Banking Crisis
2-Phase
The senior
unsecured Phase 1: Construction and developer losses Phase 2: Residential mortgage losses
ratings of
Ireland’s 3 largest  Commercial real estate prices declined over  Over 40,000 borrowers (5% of Irish mortgage
banks reflect the 59% since September 2007 loans) at least 90 days late on payments (as of
public policy Sept 30, 2010); represents EUR 7.8 billion of
decisions of the mortgages
Irish Government,  Primary driver of EUR 45 billion in bank capital
injections to date  25% of outstanding home loans (nearly 200k
for now, to mortgages) expected to be “underwater” by
preserve the 2011; some estimates as high as 350k
sanctity of the
bank senior debt  Irish residential mortgage debt soared to
market (and not EUR113 billion in March 2010 from EUR 49
mandate senior billion in 2003
bondholder
losses)
Irish Bank Senior Unsecured Ratings Irish Bank CDS
Anglo Irish AIB BoI
1200
A1 / A- (Neg) / A- (Neg)
1000

800

600
bps

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

400

200

Baa3 / BBB / BBB

BBB- 0

Aug‐09

Aug‐10
Apr‐09

Apr‐10
Jan‐09

Jan‐10
Nov‐08

Feb‐09

Jul‐09

Sep‐09

Nov‐09

Feb‐10

Jul‐10

Sep‐10

Nov‐10
Jun‐09

Jun‐10
May‐09

May‐10
Dec‐08

Dec‐09
Oct‐08

Mar‐09

Oct‐09

Mar‐10

Oct‐10
Source: The Irish Times (November 2010), Wall Street Journal (November 2010). DB Global Markets Research. CreditSights. 17
 Issue # 3: Significant Government Capital Injections
 Total capital
p injections
j to date: EUR 45 billion ((~ 30% of GDP))
Ireland’s EUR 45
billion of capital - Anglo Irish Bank: EUR 29 billion recapitalization to date (split into asset recovery and funding
injections into banks with 10-15 year workout)
Irish banks dwarfs
the planned EUR - Bank of Ireland: Recapitalized through EUR 3.4 billion equity offering earlier this year (through
15 billion fiscal which Ireland’s national pension fund (NPRF) converted EUR 1.7 billion preferred to equity)
adjustment,
dj t t andd
has exceeded the - Allied Irish: Total capital need of EUR 10.4 billion; approx EUR 3.5 raised, and remainder well
fiscal capacity of underway through asset sales, and potential share offerings and conversions to / with NPRF
the State (over
30% of GDP) - Irish Nationwide: EUR 5.4 billion re-capitalized; no viable future as independent entity
- Educational Building Society: EUR 250 million initial recap; subject to sale process
- Irish Life & Permanent: has not required any government support

Gross Fiscal Costs of Banking Crises Bank Bail-outs (% of Home Country GDP)

% of GDP A l I i hB k
Anglo Irish Bank  ~18%
18%
11.26%
Thailand 1997 Anglo‐Irish

Turkey 2000
 In total, Ireland has
South Korea 1997 RBS spent
p ~EUR 45 billion,
or ~30% of GDP,
Ireland 2008 rescuing its banks
Uruguay 2002 UBS
Malaysia 1991

J
Japan 1997 Citigroup 
Finland 1991

0 10 20 30 40 50 0% 2% 4% 6% 8% 10% 12%
18
Source: Irish Central Bank. Wall Street Journal. Financial Times. DB Global Markets Research.
 Issue # 4: Significant Bank Liability Guarantees
Overview

Ireland’s decision in
September 2010 to
extend over EUR 30
billion in bank debt
guarantees
t was a
pivotal moment in
the Irish crisis Expiry Date
 September 30, 2008: Originally introduced as CIFS (Credit Institutions
Name
Financial Support Scheme)
 December 9, 2009: Changed to ELG (Eligible Liabilities Guarantee)
 June 2011:
- Originally due to expire on September 29, 2010
- First extension to December 31, 2010
- Second extension to June 2011
- Subject to EU review every 6 months

 EUR 147 billion

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

 New senior bonds with maturities up to 5 years

Covered
Liabilities  Excludes dated subordinated debt ((as of Sept
p 29, 2010))
 Corporate and retail deposits
 Short term bank liabilities and debt securities

19
Source: Irish Finance Ministry. Financial Times. Wall Street Journal.
 Issue # 5: “Bad Bank” (NAMA) Crystallized Losses
The National Asset Management Agency
Ireland was one
Program Overview Purchases to Date
of the only
countries during
the financial  Established: December 2009  Target Size: EUR 73 billion (nominal)
crisis to move
quickly around  Chief Executive: Brendan McDonagh  Expected average discount rate: 58%
the concept of a  Approval / Timing: by European Commission;  Purchases to Date: EUR 53 billion (nominal)
“bad bank” to
all loans must be transferred by Feb 2011
remove the toxic
loans from its  Purpose: Bring stability to the banking system
bank balance by removing impaired loans from balance sheets
sheets of individual banks The creation of Ireland’s “bad bank” (NAMA)
has allowed Ireland to crystallize losses in its
Such early action  Domicile of Loans: 33% outside Ireland (6 %
to cleanse the banking sector much more quickly, and
Northern Ireland, 21% UK)
Irish bank transparently, than most other global banking
b l
balance sheets
h  Funding:
F nding Loans paid for with
ith Government
Go ernment systems impacted by the financial crisis
will pay benefits guaranteed securities (NAMA bonds)
through the The United States, for example, pursued a
recovery  Impact to Sovereign Debt: Treated as off- similar initiative for toxic bank loans in 2009,
balance sheet and not included in EuroStat debt called the PPIP loan program, but ultimately
metrics abandoned the planned policy

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

20
Source: National Asset Management Agency
 Issue # 6: High Dependence on Central Bank Funding

Irish banks have Key Issues

made record use
of both ECB and
Irish Central bank
funding
The acceleration
of this need has
been driven by an
increase in
deposit outflows,
and limited access
to private capital
markets funding
 Record ECB borrowings (as of Oct. 2010): EUR 130 billion Figures include
– Irish bank borrowings account for ~30% of total ECB loans (EUR 440 bn) funding for both
Irish and foreign
– ECB currently funding ~20% of Irish bank assets
banks domiciled in
– Equal to ~ 83% of Irish GDP Ireland
– Driven by deposit outflows and limited access to capital markets
 Record Irish Central Bank borrowings: EUR 20 billion of “exceptional liquidity” extended to
Irish banks in Sept and Oct (in addition to ECB funds)
Irish Bank ECB Borrowings European Peripheral Euro-Zone Share of GDP
(Jan. – Oct. 2010) vs. Share of ECB Funding
130 Share of GDP Share of Funding
Total ECB loans: EUR 440 bn
Ireland Total: EUR 130 bn (~30%)
120
Ireland

110
R bn

Portugal
EUR

100

90 Greece

80
Spain
p

70
0% 5% 10% 15% 20% 25%
Feb‐10

Sep‐10
May‐10

Jun‐10
Mar‐10

Oct‐10
Aug‐10
Apr‐10
Jan‐10

Jul‐10

21
Source: Central Bank of Ireland, Central Bank of Spain, Central Bank of Greece, Central Bank of Portugal, Wall Street Journal (Nov. 2010)
Th Sovereign
The S i
Section B
 Ireland’s Sovereign Crisis: 5 Key Issues
An accurate
Key Issues
assessment of the
Irish State’s debt
burden necessarily • 2010E Fiscal deficit of 32% (12.9% excluding bank rescues)
Issue # 1
requires more
– 2011 Target: Under 10%
certainty around
the liabilities of the – 2014 Target: 3%
Irish banking
system • 2010E Gross debt / GDP of 94% (~ 70% on a net debt basis)
Issue # 2
Although Ireland is – Ireland has over EUR 45 billion in cash (EUR 22 billion + SWF assets)
pre-funded – Gross and net debt / GDP projected to peak in 2013
through mid-2011,
mid 2011
its ability to access
the capital markets Issue # 3 • Highly strained access to capital markets
in early 2011 – Sovereign pre-funded through mid 2011
remains very
uncertain – Suspended remaining 2010 Government bond auctions on Sept 30
– Market access and pricing effectively prohibitive at this time
From an EU policy
perspective,
containing the • Contagion to Portugal, Spain and Italy
Issue # 4
contagion from – The “fundamentals” of Ireland, Portugal, Spain and Italy are very different
Spain and Italy is a
primary goal – Markets
M k t expectt Portugal
P t l to
t need
d funds
f d soon after
ft Ireland
I l d
– Contagion to Spain and Italy would be a “game changer”

• Contagion to the European financial system

Issue # 5
– Will depend on unfolding of crisis
– UK banks have most exposure, followed by Germany and France
– Significant ECB exposure as well
Source: DB Global Markets Research. Ireland’s National Treasury Management Agency. 23

Excluding g bank
bailouts, Ireland’s
2010E fiscal deficit
is still high at
12.9%, but is
projected to come
down below 10% in
2011, targeting 3%
by 2014
Issue #1: 32% Fiscal Deficit (12.9% Excl. Bank Rescues)
Overview of Ireland
Ireland’s
s Twin Deficits
2010E Fiscal Deficit (% of GDP) 2010E Current Account Deficit (% of GDP)
 2010E Including Bank Rescues: (- 32%)  2010E Current Account: (-1.0%)
 2010E Excluding Bank Rescues: (-12.9%)  2011E Current Account: 0.0%
 Irish Government Fiscal Austerity Plan: 4  2010 Balance of Payments: EUR 28 billion
years; EUR15 billion; EUR 6 billion front- surplus as of August 2010
loaded to 2011
 2011E Fiscal Deficit: (-9.8%)
( 9 8%) Current Account Deficit =
+ Balance of payments (exports, less imports)
 2014E Fiscal Deficit: (-3.0%) + Net factor income (interest; dividends)
+ Net transfer payments (i.e., foreign aid)
8
-3 6

4
-8
3% limit set by 2
EU Maastricht
-13
% of GDP

Treaty 0

% of GDP
-2
-18
18 Excluding bank rescues
-4
-23 -6 Ireland had a EUR 28 billion
Including bank rescues
balance of payment surplus
-8
-28 as of August 2010
32% -10
10

-33 -12

24
Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.
 Issue #2: Irish Gross Debt to GDP at 94%
Overview

Ireland’s debt to GDP  Irish government gross debt stands at EUR146.8 bn or 94% of GDP
(gross and net) are
– Approximately 70% on a net debt basis
projected to peak
in 2013 – Ireland has over EUR 45 billion in cash (EUR 22 billion + SWF assets)

 The current debt levels, and lack of clarity around Ireland’s bank sector, have created
significant “solvency” concerns with investors
– Liquidity is not a primary concern as was the case with Greece (pre-funded through mid 2011)

2010E Peripheral Total Debt (EUR bn) 2010E Peripheral Total Debt as % of GDP

Spain Greece

Greece Ireland 94%

Ireland EUR 146.8 bn

Portugal

Portugal Spain

€0 €200 €400 €600 €800 0% 50% 100% 150%25

Source: IMF (October 2010)
 Issue #3: Highly Strained Access to Capital Markets
Ireland may be pre- Ireland’s
Ireland s 10 Year Government Bond Yields (Jan 1
1, 2010 to Present)
funded through 9
mid 2011 (with ~ Sept 30: Irish government suspends
EUR 46 billion in 8 bond sales for the remainder of 2010
liquid assets), but
the primary 7
concerns around
the Irish debt crisis 6

are not liquidity

based 5
%

4
Jan‐10
Jan 10 Feb‐10
Feb 10 Mar‐10
Mar 10 Apr‐10
Apr 10 May‐10
May 10 Jun‐10
Jun 10 Jul‐10
Jul 10 Aug‐10
Aug 10 Sep‐10
Sep 10 Oct‐10
Oct 10 Nov‐10
Nov 10
Rather,
R th ththe
solvency of the Ireland’s Favorable Maturity Profile is Not the Primary Focus of Investors
banking system,
and the State itself, 20
has been the
primary focus of 15
investors, and the
primary obstacle to
EUR bn

10
capital markets
access
5

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

“In our super-cycle era of Western market leverage, we need capital markets to be fully functioning 24 / 7. Any
blockages leave the numerous refinancing entities vulnerable. It just so happens that those currently in need of the
most refinancing are Governments.”
~ Jim Reid, Deutsche Bank Macro Strategist (April, 2010)
26
Source: Bloomberg. Ireland’s National Treasury Management Agency
 Issue #4: Contagion to Portugal, Spain & Italy
Peripheral 10yr Credit Spreads vs. Germany Peripheral 5yr CDS Spreads
The risks posed by
(Oct. 1, 2010 – Present) (Oct. 1, 2010 – Present)
Greece, Ireland
and Portugal  Irish 10y spread over Germany reached  Irish 5y CDS reached record levels of 595
(combined 5% of record levels of 646 bps (and bond yields bps on November 11, 2010
EU) can be well 9.1%) on November 11, 2010
absorbed by EU
It l
Italy G
Greece P t l
Portugal S i
Spain It l
Italy G
Greece P t l
Portugal S i
Spain
rescue
mechanisms… 1200 1200

…however,
1000 1000
contagion to Spain
y ((over 20%
and Italy %
of EU) would raise 800 800
significant
questions on both

bps
the willingness and 600 600
bps

ability of the EU to
finance a rescue 400
400

To be sure, the
EFSF would not be 200 200
sufficiently
adequate in size
0 0
for a bailout of Italy

1‐Oct

8‐Oct

15‐Oct

22‐Oct

29‐Oct

5‐Nov

12‐Nov
1‐Oct

8‐Oct

15‐Oct

22‐Oct

29‐Oct

5‐Nov

12‐Nov
(and some insist
the same is true for
Spain)

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

27
Source: Bloomberg
 Issue #4: Contagion to Portugal, Spain & Italy
Markets strongly
expect Portugal
will have to follow
Greece and Ireland
in tapping EU / IMF 2010E Portugal Spain Italy
funds
GDP (EUR billions)
billi ) 171 1
171.1 1 051
1,051 1 557
1,557
Spain has
positively % of EU Economy 1.4% 8.5% 12.6%
differentiated itself
on fiscal policy,
Unemployment Rate 10.7% 20% 8.7%
but markets are
still very focused
on this risk 2010 Sovereign Debt 142.2 667.2 1,843.6

To be sure, 2010 Debt / GDP 83.1% 63.5% 118.4%

contagion of the
p
crisis to Spain and 2010 Fiscal Deficit -7.5% -9.0% -4.9%
Italy would be a
watershed moment 10 Yr Gov’t Yield 6.7% 4.3% 4.7%
in the European (Nov 20, 2010)
debt crisis…
5 Year CDS 416 bps 260 bps 181 bps
…a game
game-changer
changer (Nov 20, 2010)

This containment Key Questions:

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

Source: Bloomberg as of November 20. DB Global Markets Research, IMF (October 2010), Portugal Finance Ministry, Spain Finance Ministry, Italy 28
Finance Ministry
 Issue #5: Contagion to European Financial System
Investors have Domestic vs
vs. Foreign Holdings of Debt by Country
begun to pay much
closer attention on a  Ireland heavily relies on foreign investors to finance government debt:
country’s reliance
on international - A sovereign’s dependency on international capital markets is a critical area of focus in sovereign risk
capital markets for analysis
funding - Japan, for example, has had significant sovereign debt levels for two decades but has largely
avoided a funding “crisis” because it has been able to finance its onerous debt levels domestically
To this end, Ireland
is one of the most Irish Debt Holdings
heavilyy reliant Domestic Foreigng
countries on foreign Foreign holdings 28% 72%
holdings of its Domestic holdings
public debt (a
concern which the
EU / IMF bailout
%

should help
mitigate)

A large part of Irish

debt is held by the
European financial
sector including
banks, insurance
companies, and
pension funds

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

29
 Issue #5: Contagion to European Financial System
Key Details Top 20 Banks by Net Exposure

Similar to the Greece  Bank sector exposure to the “Irish crisis”

crisis, the European can take many different forms: Bank Exposure
banking system is – Direct losses on loans, bonds and other 1 RBS £4.3 bn
the primary source
off “contagion’
“ t i ’ ini the
th
debt issued 2 Allied Irish Banks € 4.1 bn
Irish crisis – Losses at individual, corporate or sovereign 3 Bank or Ireland € 1.2 bn
level 4 Credit Agricole € 929 mm
– Higher costs of capital 5 HSBC $816 mm
– Less lending
g activity
y 6 Danske Bank € 655 mm
7 BNP Paribas € 571 mm
– Lower profitability via economic impact
8 Group BPCE € 491 mm
9 Societe Generale € 453 mm
Foreign Banks’ Total Exposure to Ireland 10 Banco BPI € 408 mm
(by Nationality
Nationality, as of March 31,
31 2010) 11 LBBW € 408 mm
(US$ Billions) 12 Bank of Cyprus € 356 mm
UK 13 DZ Bank € 310 mm
Germany
14 Postbank € 300 mm
15 Norddeutsche Landesbank € 274 mm
U.S.
16 WestLB € 244 mm
France
17 WGZ Bank € 244 mm
Italy
18 Caixa Gral. De Depositos € 231 mm
Japan 19 Rabobank € 222 mm
Spain 20 SNS Bank € 209 mm
€0 €50 €100 €150 €200 €250

30
Source: Financial Times. Wall Street Journal. Bank of International Settlements.
DB European Peripheral Economic Forecast
Reall GDP
R Consumer
C Current Account Fiscall Balance
Fi B l
(% Growth) (% Growth) (% of GDP) (% of GDP)

2010E 2011E 2010E 2011E 2010E 2011E 2010E 2011E

-0.5% 1.2% -1.5% 0.5% -1.0% 0.0% -29.2% -9.8%

-4.3% -2.7% 4.7% 1.7% -8.0% -7.0% -8.0% -7.6%

1.6% 0.0% 1.4% 1.5% -10.5% -8.0% -7.5% -6.0%

-0.5% 0.0% 1.6% 1.4% -5.0% -4.5% -9.0% -7.1%

31
Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.
P t ti l S
Potential Solutions
l ti
Section 3
 Potential Solutions: 5 Key Steps
What do capital markets investors want? P t ti l Solutions:
Potential S l ti 5 Key
K Steps
St

Transparency:
• On bank sector losses (in stress-case scenario)
Consistency:
• On Government policy decisions, both nationally
and at the EU level
• Agreement among EU countries on path forward
Clarity:
• On the treatment of bondholders, currently and in
the future
• Markets will re-price risk accordingly
Confidence:
• On ability to deliver fiscal austerity measures
• In commitment of opposition political parties, and
social willingness to support
Certainty:
• On all of the above, as much as possible
Step # 1:
• EUR 80 – 90 billion from the EFSF / IMF / EFSM
– For both the sovereign and bank sector
Step # 2:
• Acceleration of Ireland’s EUR 15 billion fiscal
adjustment
– Credible support from opposition parties critical
Step # 3:
• Continued ECB support
– Sovereign bond purchases / bank liquidity
Step
p # 4:
• EU creation of an “Orderly Restructuring Mechanism”
– Clarity around treatment of bondholders, both
currently, and in the future
Step # 5:
• Growth from Ireland’s competitive economy
– Maintaining Ireland’s corporate tax rate of 12.5%, and
strong FDI flows, will be important to its growth outlook

“There may be a contradiction between the interests of the financial world and the interests of the political world. We cannot
keep explaining to our voters and our citizens why the taxpayer should bear the cost of certain risks and not those people who
have earned a lot of money from taking those risks.” ~ Angela Merkel, German Chancellor (Nov, 2010)

33
 Step # 1: EUR 80-90 billion from EFSF/ IMF/ EFSM
On Nov 21, Ireland’s
Question What we do and don’t know (as of Nov 21)?
Prime Minister
and EU officials
indicated that What?  Sunday, Nov 21: Ireland’s cabinet approves application for EU / IMF aid
Ireland will in fact – Negotiations on details should continue for several weeks
apply for a bailout
from the European  2 part bailout package expected (though details not finalized as of Nov 21):
Union and IMF 1. Sovereign: Funds for the Sovereign to cover 2011 – 2012 funding
2. Banks: Ireland pushing for “contingency fund” structure to recapitalize its
To be sure, banks (details to be determined by further “stress testing’ of the system”)
negotiations
underway y in Dublin
will continue over How much?  EUR 80 – 90 billion expected (less than Greece’s EUR 110 billion)
the coming weeks  Approximately 1/3 expected to come from the IMF
and be focused on a
closer examination
When?  EU/ IMF/ ECB Assessment: Began in Dublin on Thurs, Nov 18
of Irish bank balance
sheet exposures
exposures…
 Application: On Nov 21, Ireland’s cabinet approves application for EU/ IMF aid
…as well as
resolving the  Negotiations on Conditionality: Likely to take weeks; structure of bank
inherent conflict of contingent capital fund, and Irish corporate tax rate, will be a key focus
interest between the
EU’s
EU s desire to
contain the Where?  Review and negotiations underway in Dublin, Ireland
contagion, and
Ireland’s desire to  At the Irish Central Bank, Ireland’s bond agency, and the Finance Ministry
maintain the
independence of its
economic i policy
li “The European authorities have agreed to our request. The formal process of negotiation will
now commence…to be finalized shortly, within the next few weeks.”
~ Brian Cowen, Irish Prime Minister (on Nov 21, 2010)

34
Source: Deutsche Bank Global Markets Research. Public comments of key Irish and EU officials on Nov 21, 2010.
 Step # 1: EUR 80-90 billion from EFSF/ IMF/ EFSM
In addition to Sources of EU / IMF Rescue Funds (EUR 750 billion / US$ 1 Trillion)
potential bilateral
loans from the UK European Financial Stability European Financial
and Sweden, the EU IMF Loans Stability Mechanism (EFSM)
Facility (EFSF)
has assembled a
EUR 750 billion war
chest to address the Size  € 440 billion  € 250 billion  € 60 billion
EU sovereign crisis
(over US $1 Trillion)

 Self funding vehicle:  IMF  Expansion of pre-

Approximately 1/3 of Source of existing EU Balance of
g
the aid for Ireland is Funding - AAA rated
P
Paymentst facility
f ilit
expected to come - Will not pre-fund (as needed)
funded with EU bond
from the IMF  Guarantees from EU member issuance
states
– Previously used in 2008
 UK not involved in funding for Hungary, Latvia, and
However, use of the
EFSF for a Romania
significant portion of – UK is involved in
the package could funding
be viewed as critical
to its credibility in  EU Approval: Must have  Subject to IMF  EU Approval: Only
the market Terms unanimous support
pp from all g
negotiation and majority needed (not
members conditionality unanimous as for EFSF)
 Maturity: 3-5 years (expected)
 3 year Rate: 3m Euribor + 300
bps
Requires unanimous EU
 4-5 y
year Rate: 3m Euribor + approval and high conditionality
400 bps
 Service Fee: +50 bps

35
Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.
 Step # 1: EUR 80-90 billion from EFSF/ IMF/ EFSM
Overview of the EFSF

Use of the EFSF for

the Irish Crisis will Details Funding
be important for its
credibility, and will  Headquarters: Luxembourg  Self-Funding vehicle:
lik l be
likely b well
ll
received by markets  CEO: Klaus Regling - Executed by German Debt Office
(DMO), but EFSF is issuer
 Operational: August 4, 2010
- Guaranteed by member states
 Ratings: AAA/ Aaa/ AAA
- Estimated 1week to raise capital
Guarantees  Expiry: Later of June 30, 2013 (3 years),
or at latest maturity date of outstanding  No pre-funding (funds only upon request)
billions loans (up to 5 years)
Germany € 122.8
€ 92.3  Conditionality: Linked to strict policy Terms
France
Italy € 81
81.11 agreement pursuant to MoU with the EC
 Maturity limits: None (3 – 5 years
Spain € 53.9
 Guarantee: Over-collateralized; 20% in expected)
Netherlands € 25.9
excess of total funding volume
Belgium € 15.7  No currency limitations (EUR, US$, etc.)
Austria € 12.6
 ECB eligible: Yes  Rates: Same as Greece
Portugal
g € 11.4
Finland € 8.1  Approvals: Requires unanimous support - 3 years: 3m Euribor + 300 bps
Ireland € 7.2 by participating countries
Slovakia € 4.5 - 5 years: 3m Euribor + 400 bps
Slovenia € 2.1
Luxemburg € 1.1
C
Cyprus €00.9
9  There is no cap on EFSF funds for an Ireland bank sector recapitalization
Malta € 0.4  EFSF funds in place are sufficient to cover Ireland, Portugal and Spain, but not Italy
Total € 440.0  The implications of Italy having to tap the EFSF would be “devastating”

36
Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.
 Step # 2: Acceleration of Fiscal Adjustment
Ireland is in the Nov. 4, 2010: Ireland Proposes further
f Fiscal Adjustment
process of
accelerating a very
aggressive (and IMF- Details Planned Composition of Fiscal Adjustment
like) fiscal
adjustment program Largely Mix (broadly Largely
Announcement Timing:
that is impressively Deficit (2009) Expenditure- equally- Revenue-
front-loaded for 2011  Late November announcement expected based based) based
 Inclusion in Dec 7 budget deadline High deficit Ireland Greece
Credible support (above 10% of
from opposition  Subject to EU / IMF conditionality GDP)
Japan India
political parties,
p p , and Spain United States
the broader
UK
population, will be Total Size:
critical to investor Portugal Russia
reaction  Total Adjustment: EUR 15 billion over 4 years
Canada
 Breakdown: Medium
The Nov 4 France
- EUR 6bn in 2011 (front-loaded) deficit
announced plan, of Italy
(between 5%
course, is now - EUR 9bn 2012-2015 Latvia
and 10% of
subject to EU / IMF
conditionality GDP) Lithuania
Fiscal Targets: South Africa
Turkey
 2011 fiscal deficit: Below 10% by 2011 (from
12.9% currently, excluding bank rescues) Australia Mexico China
Low deficit
 2014 fiscal deficit: Below 3% (as required by Germany
(below 5% of
EU’s Maastricht Treaty) GDP) Korea
Saudi Arabia

“We can opt to do this adjustment or we can keep expressing ourselves through anger and
the denial of the problem.”
Brian Lenihan, Irish Finance Minister
37
Source: IMF: “Fiscal Exit: From Strategy to Implementation”
 Step # 3: Continued ECB Support

Irish Bank ECB Borrowings

Continued ECB Overview
(Jan. – Oct. 2010)
support is critical
to resolving the  Continued ECB support is critical on both: 130
Irish and European Ireland bank funding
sovereign debt 1 Sovereign debt purchases
1. purchases, and 120 now accounts for
crisis 2. Bank sector liquidity, as needed ~30% of ECB funding
110

EUR bn
One of the key  Sovereign debt purchases: sharply
reduced since June put recent pick-up in Irish 100
goals of the EU/
IMF rescue bonds
90
package, however,
 Bank sector liquidity: ECB role has been
will be to reduce
formidable, especially for Ireland (~30% of ECB 80
Ireland’s bank
sector dependence total)
70
on ECB funding – Key goal of EU / IMF bailout is to

ug‐10
Jaan‐10

pr‐10
Fe b‐10

ul‐10

Se p‐10
Maay‐10

Jun‐10
Maar‐10

Occt‐10
reduce this reliance

Ju
Ap

Au
ECB Sovereign Debt Purchases Since May 10, 2010

16000
14000 Cumulative Total: EUR 65.1 bn
12000
10000
EUR Mm

8000
6000 Recent pick-up in Irish bond purchases
4000
2000
0

38
Source: ECB
 Step # 4: Clarity on EU’s Restructuring Mechanism
Clarity on the Key Facts on the EU’s “Orderly Restructuring Mechanism”
treatment of
bondholders is  October 29, 2010: Germany presents a proposal of a 2 tier permanent debt crisis mechanism to be
critical to well effective by 2013:
functioning bond
markets - Phase 1: Fiscal austerity measures for EU countries struggling with fiscal targets
- Phase2: Private creditors would be subject to haircuts
The uncertainty on
this topic between  November 12, 2010: Joint announcement at G-20 partially alleviating market concerns:
October 29th and
- Mechanism will only apply to new debt issued after 2013
November 12th was
y disruptive
very p to - No forced losses for existing bondholders
markets
 December 15 – 16, 2010: Details of a future “Orderly Restructuring Mechanism’ (applicable after
Investors will 2013) to be disclosed in the European Council meetings
adjust and re-price
risk accordingly (as Pros and Cons of Orderly Restructuring
long as clarity is
provided)
Pros Cons
For now, the  Could potentially improve market confidence:  “Adverse selection”:
confusion around
the details and - Assures tax payers that creditors will bear - “Restructuring premium” would make
governance of this restructuring costs restructuring more expensive for countries trying
new plan has to correct fiscal imbalances
- Cheap pre-funding option for Ireland and Portugal
created an - Fiscally mismanaged countries might opt to use
“overhang” issue in - Proposes a more organized and standardized
the mechanism as a cheaper restructuring option
the market restructuring process
 Potential opposition from other governments
 Could potentially “smoothen” crisis situations by
and private sector for “alternative”
alternative measures
making
ki use off th
the EFSF
 Lack of clarity if not designed and executed
- Less risk of lengthy litigation
with consistency
- Flow of priority financing
39
Source: Deutsche Bank Global Markets Research. Mark Wall. Thomas Mayer. Gilles Moec.
 Step # 5: Growth from Ireland’s Competitive Economy
Despite the crisis, Ireland’s Position in Global Rankings European Corporate Tax Rates (by Country)
Ireland still ranks
Rank Competitiveness Ranking 35 Ireland: 12.5%
as one of the most
competitive EU Average: 23%
30
economies in the #1 For corporate taxes
world 25
#4 For availability of skilled labor
To be sure, 20
maintaining its

%
#4 For openness to new ideas 15
competitiveness
will be critical to 10
deliveringg on an #6 For labor productivity
aggressive fiscal 5
austerity program #7 For availability of financial skills
0
Importantly, #7 For flexibility and adaptability of people
Ireland’s foreign
direct investment
(FDI) has held up DB’s 2011E Euro Peripheral Real GDP Growth Estimates
very well during the
crisis 1.5 1.2
1.0
DB has forecasted 0.5
positive GDP 0 0
0.0
%

growth for Ireland ‐0.5

in 2011
‐1.0
‐1.5
‐2.0
‐2.5
2.5
‐3.0 ‐2.7
Ireland Portugal Spain Greece

Source: Deutsche Bank Global Markets Research (Mark Wall, Thomas Mayer, Gilles Moec. IMD World
40
Competitiveness Yearbook 2010). EuroStat.
P t ti l U.S.
Potential U S Capital
C it l Markets
M k t Implications
I li ti
Section 4
 Summary Implications for Markets
Directional
M k t
Markets I
Impactt P t ti l IImplications
Potential li ti (D
(Depending
di on Crisis
C i i Depth)
D th)

U.S.  Currently being driven by 3 macro themes:

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

“The two main concerns [in markets] are the sovereign debt crisis in Ireland and the inflation bubble risk in China.
Global growth depends on the resolution of those two problems.” ~ European Asset Manager (November 19, 2010)
42
 Summary Implications for Markets
Directional
Markets Impact Potential Implications (Depending on Crisis Depth)

 Direct Exposure: $114 billion of direct exposure to Ireland (loans, bonds and other debt
U.S. Banks
issued by Irish companies, individuals and governments)
 More indirect impact: U.S. bank spreads still very vulnerable to exogenous shocks at this
time; contagion effect; higher cost of capital

European IG  Full impact will depend on extent of the contagion

Bond Markets  Sovereign Market: Stabilization of this sector is critical to the overall market
 Corporates: European corporate credit markets have proven to be remarkably resilient as
compared d tto the
th peakk off th
the G
Greek
k crisis
i i iin M
May 2010
– The blue-chip iTraxx Europe index of 125 investment grade corporates (as well as the
Europe Crossover index of 50 largely non-IG names) has remained resilient as the Irish
crisis has peaked
– Corporate credit curves have also steepened (bullish sign showing comfort on front end)
 Financials: Significantly more vulnerable, but market still very much open for “stronger
financial players”
– Mid-caps and second tier financial names have been more impacted
 Public Policy Issues: Critical to get market clarity on the issue of “bail-ins” (creditor losses
on rescues)) very y soon in order to improve
p investor risk appetite
pp
European  UK Bank Exposure: US$ 222 billion of direct exposure to Ireland (loans, bonds and other
Banks debt issued by Irish companies, individuals and governments)
– German Bank Exposure: US$ 206 billion
– French Bank Exposure: US$ 86 billion
– Italian
It li Bank
B k Exposure:
E US$ 29 billi
billion
– Spanish Bank Exposure: US$ 16 billion
 Cost of capital: Strong upward pressure if crisis accelerates; higher debt costs and
increased equity capital needs
43
 Summary Implications for Markets
Directional
Markets Impact Potential Implications (Depending on Crisis Depth)

Commodities  Impact from acceleration of Irish crisis in November has been limited
(Oil, Other)  Will increase markedly if contagion not contained
 Oil and other commodity asset classes will experience downward pressure on “Risk
Risk Off”
Off
th
days in the market (such as November 16 when Ireland initially refused EU rescue
loans)

Gold  Has and will continue to be a “safe haven” for investors when the Euro crisis
accelerates
 Has also been an important market for investors to hedge sovereign risk generally

Euro / US$  “Relief rally” expected on the back of the Irish application for EU / IMF aid on Nov
Exchange 21 (and likely to track the pace of negotiations in subsequent weeks)
Rate  As the crisis accelerated in early November, the Euro moved down sharply from
1.43 to 1.35
– Not nearly as strong a decline as with the Greece crisis in May
– Generally, if the contagion accelerates, downward pressure on the Euro has the
potential to be q
p quite strongg
 Contagion to Spain and Italy would be a “game-changer”
– Potentially “too big to fail”?
– Would raise questions about the longer term viability of the Euro

44
 The VIX Volatility Index
VIX Daily Closing Values (Sep
(Sep. 1
1, 2008 – Present)
The VIX has not
returned to the 80  Greece Crisis Peaks (Week of May 3rd): VIX jumped a breathtaking 85%
levels of the Lehman  Irish Crisis Accelerates (Oct 29 – Nov 16): VIX jumps ~ 5%, but then rallies to lower levels as
bankruptcy, but did details of Ireland’s reluctant acceptance of EU / IMF aid begins to emerge
reach as high as 40
in May during the 90
peak of the Greece
crisis
80
For now, the index Lehman Bankruptcy
has remained
largely contained as 70
the Irish crisis has
accelerated in
November 2010
60

50 Greece Crisis Irish Crisis

40

30

20

10
Aug‐09

Aug‐10
Jan‐09

Apr‐09

Jan‐10

Apr‐10
Feb‐09

Jul‐09

Sep‐09

Feb‐10

Jul‐10

Sep‐10
Nov‐08

Nov‐09

Nov‐10
Jun‐09

Jun‐10
May‐09

May‐10
Dec‐08

Dec‐09
Mar‐09

Mar‐10
Oct‐08

Oct‐09

Oct‐10
45
Source: Bloomberg
 Impact on the Euro
To be sure
sure, we Overview (as of Nov 21,
21 2010)
expect a relief rally
in the Euro
following the  Despite a strong rally since September, the Euro declined sharply in November as the Irish
Ireland EU/ IMF Crisis accelerated:
rescue package - Irish Crisis High: On Nov 4, Euro /US$ hit its highest point since January ($1.43)
However, the scope - Irish Crisis Low: On Nov 16, following Ireland’s refusal to tap EFSF funds, Euro/ US$ closed at a
and pace of 3 month low (1.35)
contagion will be
 What to expect from here?
critical to any
longer term – Relief rally expected coming out of the Irish bailout announcements of Nov 21
assessments t
– The ability to “contain the contagion” of the crisis will be critical to any forecasts from here

Euro/USD Spot vs. Euro/USD Purchasing Power Parity (PPP) (January 1, 2010 – Present)

The Euro has Euro/ USD

Euro/ USD PPP PPP+‐20%
PPP 20% Band
Band ‐20%
20%
traded around 20%
above its 1.5
purchasing power
1.4
parity since
January 1.3
USD/EUR

1.2

1.1
Irish Crisis Accelerates
1

0.9

0.8
Jan‐10 Feb‐10 Mar‐10 Apr‐10 May‐10 Jun‐10 Jul‐10 Aug‐10 Sep‐10 Oct‐10 Nov‐10
46
Source: Bloomberg
 Impact on the Euro
We expect a relief Dual Views Over the Future of the Euro
rally in the Euro
following the Bullish View Bearish View
Ireland EU/ IMF
rescue package…  Market has priced in the EFSF:  The EFSF has not been proven:

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

47
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