Professional Documents
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August 7, 2011
Strictly Private and Confidential
Situation Overview
On August 5th, S&P lowered the US long-term sovereign credit rating from AAA to AA+ due to the US debt burden and uncertainty that long-term deficit reduction is achievable in the current political environment.
S&P's action lowered the US long-term credit rating to AA+ with negative outlook The US short term sovereign rating of A-1+ was affirmed S&P removed the CreditWatch negative designation from the US sovereign rating based on its view that the August 2nd Budget Control Act Amendment of 2011 ( h D b C ili A A d f (the Debt Ceiling Amendment) eliminated the risk of near-term d f l d ) li i d h i k f default S&P based its downgrade on its view of the trajectory of the US public debt burden over the next decade and its view of greater policymaking uncertainty in addressing US fiscal challenges S&P noted that the fiscal consolidation plan announced August 2nd falls short of the amount necessary to stabilize the government debt burden Prior commentary by S&P had telegraphed a probable downgrade if the Debt Ceiling Amendment generated less than $4 trillion in spending cuts (vs $2 4 trillion announced) (vs. $2.4 S&P commented specifically on the volatile and unpredictable legislative environment as a key driver of its downgrade, as detailed on the following page S&P suggested that policymaking risks to resolving the US debt burden outweighed the underlying US fundamentals, noting that the rating agency's view of the USs other economic, external, and monetary credit attributes, which are the basis of the sovereign rating, are unchanged S&P also noted the possibility for further downgrade of the US sovereign rating to AA within the next 2 years if: Spending reductions turn out to be lower than levels announced in the August 2nd agreement; Interest rates rise, increasing the cost of servicing the national debt; or New fiscal pressures" result in higher government debt Moody s Moodys and Fitch affirmed their Aaa / AAA US sovereign ratings on August 2nd following announcement of the Debt Ceiling Amendment although Amendment, Moodys maintains a negative outlook S&P generated US public debt projections for the coming decade across three scenarios, with resulting debt-to-GDP ratios for each scenario, which are detailed in the Appendix
Joint Release from the Fed, Fed FDIC, NCUA and OCC
US government issued a joint release on Friday addressing the action by S&P to help alleviate market concerns and provide g guidance to banking organizations g g The risk weights for Treasury and other securities issued / guaranteed by the US or government-sponsored entities will not change The t t Th treatment of Treasury and other t fT d th securities issued / guaranteed by the US or government-sponsored entities under other federal banking agency regulations will also be unaffected
On Monday, August 8th, S&P will issue separate releases concerning affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors.
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Perception of US Treasuries as the highest quality instruments available among a set of less attractive alternatives has maintained low rates significantly below long term averages, although in the longer term this logic may come under pressure
3.25% 0.70% 0.45% 0.20% 0.49% 0.29% 2.25% 7/22 7/24 7/26 7/28 7/30 2yr UST 3yr UST 8/1 8/3 8/5 7/22 7/24 7/26 7/28 7/30 10yr UST 8/1 8/3 8/5 2.75% 2.56%
3.00% 2.00% 1.00% 1 00% 0.00% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
2yr UST 2yr UST Average 1yr Swap Rate 3yr Swap Rate Average 5yr UST 5yr UST Average 3yr Swap Rate 10yr UST 10yr UST Average 1yr Swap Rate Average
5yr UST
30yr UST
Average 0 bp
USD Considerations
Potential for knee-jerk USD weakening on the Asia open, but Citi does not expect this to be maintained General move towards risk reduction could be USD positive
Foreign buyers could potentially shift their holdings away from USD through th US T th h the Treasury market, h k t however th current risk appetite the t i k tit and the status of the of the USD as the worlds reserve currency will likely mitigate selling pressure Less favorable capital flows could weigh on USD in the medium-term
4
The municipal market had anticipated the downgrade. Citi expects that tax-exempt bonds from states that are more closely linked to the federal government (healthcare bonds, housing revenue bonds, federal highway grant anticipation bonds) will see the greatest impact. Revenue bonds that have standalone ratings and are not reliant on the US for support should be less affected
Citis Expectations
Financials Citi expects that financial spreads will experience gradual widening as a result of the downgrade FIG entities viewed as being supported will be impacted in the event of a downgrade, including select US insurance and bank issuers Potential investor rebalancing away from systemically-supported US financial institutions given their implicit linkage with the sovereign, particularly the money centers Main focus will be on US financial institutions that lie at the lower end of each rating band (AAand A-) as any downgrade could force rebalancing based on investment criteria A) The unlikely scenario of a downgrade on banks below the A-1 rating currently received would certainly impact access to money market funding. However, most US banks have diversified away from CP for funding post-credit crisis Corporates Citi expects that higher-quality corporate spreads will largely remain unaffected, while BBB rated credits might see modest spread widening Current expectation is that highly rated corporates in the US which do not benefit from government highly-rated US, support, will not see any modifications to current ratings The rating agencies have suggested that it is possible for corporate bonds to receive a higher rating than their sovereigns 5 Higher-rated credits could benefit from the downgrade as investors may look to switch out from higher-beta financial bonds into lower-beta corporate bonds
Spread (bps)
04/26
05/21
06/15
07/10
08/05
IPOs
$28 $25 Proceeds ($BN)
Follow-Ons
$56 $45 Proceeds ($BN) $45
Convertibles
Proceeds ($BN) $13
$12
$15 $11
$5 $ $3
$3
$9
Defensive Rotation
Market Indices Consumer Staples Telecom Utilities Information Technology Healthcare Consumer Discretionary Industrials Financials (2) Materials Energy
Source: Factset as of 08/05/11. (1) S&P 500 peak (04/29/11). (2) Includes Real Estate.
Last Week (2.5%) (2.9) (3.8) (6.2) (6.8) (8.1) (8.3) (9.2) (9.5) (10.0)
2011 YTD 1.9% (5.4) 1.5 (3.2) 0.8 (2.6) (8.9) (15.8) (10.3) 0.0
Peak To Date(1) (4.7%) (9.2) (3.8) (8.9) (9.8) (10.2) (18.0) (18.0) (15.5) (15.3)
Investor Selectivity
Median Follow-On File/Offer Performance ed a o o O e/O e e o a ce
Q4 '10 Fo ollow-On File to Offer Q1 '11 Q2 '11 Q3 '11
(6.0%)
(6.0%)
(6.1%)
( 9%) (7.9%)
Advice To Issuers
Markets Last weeks pressure in expectation of rating downgrade European overhang; anticipate continued defensive rotation p g; p Issuance Observe markets and launch on stable footing; windows open and close rapidly Choose underwriters with global differentiated distribution capabilities IPOs Flexibility on size and price range - fine tune prior to launch Assess opportunity for pre-sounding including cornerstone/anchor investments Follow-Ons Minimize market exposure and launch smaller - increase through oversubscription Equity Linked Convertible market underpenetrated Sell equity at premium; replacement to widening fixed income rates Share re-purchase strategies (open market / ASR / levered)
Q1 '10
Source: Citi Research.
Q2 '10
Q3 '10
Q4 '10
Q1 '11
Q2 '11
Q3 '11
The market will benefit from relatively modest supply of "must-go" issuance in the near term, a different dynamic from mid 2007 to early 2009, where pent up supply from committed LBO issuance, corporate short term maturities, and a greatly reduced bank loan market led to unfavorable supply / demand technicals y y Key takeaways for the near-term issue market 1. 2. 3. Market characterized by windows of opportunity as economic data and European debt crisis headlines drive fluctuations between risk on and risk off Negative bias around issuers with high vulnerability to either a US double dip recessionary scenario (particularly those in cyclical sectors with weaker balance sheets) or reductions in government spending (government contractors, companies subject to reimbursement risk) Positive bias for issuers in non-cyclical industries and large companies with international exposure (non-PIIG) who can take advantage of economic diversification and a potential weakening of the USD
The high yield market started to price in weakening economic data in July, and will remain very focused on economic releases as a driver of sentiment
One longer term concern is the performance of over-leveraged LBOs in a potentially low growth environment with a soft equity market High Yield Interest Rate Environment
Despite a recent reversal, the trend in the high yield market over the past 12 months has been progressively lower yields..
10%
LTM Issuance: $324.1 bn 2011 YTD Secured Issuance: $52.6 bn 2011 YTD Issuance: $183.3 bn
Aug
Sep
Feb
Mar
Jun
Aug
8/20
9/24
10/29
12/3
1/7
2/11
3/18
4/22
5/27
7/1
8/5
Week Ended
The ABS market has been resilient in the face of broader market volatility resulting from European sovereign debt crisis and the recent US debt ceiling standoff
LIBOR
EDSF
Swaps
g p Although we expect the markets will be receptive to new issue almost immediately, pricing tension will be maximized in cleanest asset classes
Feb-11 Apr-11 May-11 Jul-11 All-in Auto AAA Yield Trendline
Jan-11
Maintain preparedness to issue in a volatile market where windows will open and close quickly
Appendix A di
Base Case Scenario S&Ps Assumptions S&P A ti $2.1 trillion f the $2 1 t illi of th spending di reductions are implemented 2001 and 2003 tax cuts, due to expire in 2012, remain in place GDP growth of 3%, CPI at 2%
Upside Scenario $2.1 trillion f the $2 1 t illi of th spending di reductions are implemented 2001 and 2003 tax cuts for high earners lapse from 2013 onwards GDP growth of 3%, CPI at 2%
Downside Scenario $1.2 trillion in $1 2 t illi i second round of d d f spending cuts does not occur as planned 2001 and 2003 tax cuts, due to expire in 2012, remain in place 50-75 bps rise in funding costs (i.e. 10-year bond yields) 2013 onwards GDP growth of 2.5%, CPI at 1.5%
Debt / GDP 2011 2015 2021 Rating Outcome 74% 79% 85%(1) AA+ with negative long-term outlook 74% 77% 78% AA+ with stable long-term outlook 74% 90% 101% AA long-term rating
(1)
On Friday the US Treasury posted on its blog (http://www.treasury.gov/connect/blog/Pages/Just-the-Facts-SPs-2-Trillion-Mistake.aspx) that the debt-to-GDP ratio in this scenario should be 79% rather than 85%, as S&P misread congressional baseline economic assumptions. This discrepancy apparently generated a $2 trillion difference in the calculated debt-to-GDP ratio
No impact expected where p p ratings are based on standalone basis Sovereign rating downgrade could build negative pressure on higher rated b k t d banks
No automatic rating impact, but issuers would be capped at 1-2 notches above sovereign Impacted by the rating level of the credit enhancement provider (which could be downgraded)
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