1. Global Finance in Uncharted Waters World Affairs Council – North County Chapter April 15, 2010 1

2. Capital Allocation Transmission between Savers & Borrowers Match Investment with Opportunity Manage Financial Risk (example: insurance)(loans) Systemic Liquidity: Trading & Speculation Payments Processing 2 Purpose of the Financial System

3. The Debt Supercycle Borrowing as a Way of Life borne of Financial Incentives and American Exuberance 3

4. 4 Total Credit Market Debt as a % of US GDP

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12. 12 Falling Interest Rates Encouraged Borrowing

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15. The Shadow Banking System Non-Bank Finance 15

16. 16 Securitization

17. 17 Traditional Lending

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20. Increase Credit Flows (Earnings) without Increasing Leverage Manage Risk by Selling Risk Insurance Companies Foreign Banks Special Investment Vehicles (commercial paper)(borrow short, invest long) Warehouse hi-yield assets Repo deals 20 Why Securitize?

21. Failed Regulation Regulatory Arbitrage Collapse of Lending Standards Fraud (borrowers and lenders) Agency conflicts Crisis of the Quants Move to California… 21 Problems

22. Credit Default Swaps Useful financial tool or The Latest Trick in the Casino 22

23. Invented by JP Morgan 1994 Is a bilateral contract between the buyer and seller of protection Swap (buy/sell) risk exposure The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults (1-10yrs; 5yrs) A holder of a bond may “buy protection” to hedge its risk of default AIG 23 Defining Credit Default Swaps

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25. “Naked credit default swaps” (no debt holding) allow traders to speculate (long or short) Constitutes most of the market in CDS Counterparty Risk (AIG dilemma) ABS, SIVs 25 Speculating with CDS

26. 26 Derivatives

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28. Regulatory Reform Move OTC derivatives trade onto Exchanges 28 Regulation

29. Sovereign Debt Endgame of the Debt Supercycle 29

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31. 31 US Federal Debt: 1940-2010

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36. 36 Japan - National Debt

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38. State & Local Govt Pensions Infrastructure news032910GrowingStateDebtWoesUS recently recalculated the value of the 50 states’ pension obligations the way the bond markets value debt. They put the number at $5.17 trillion. After the $1.94 trillion set aside in state pension funds was subtracted, there was a gap of $3.23 trillion — more than three times the amount the states owe their bondholders. 38

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41. Debt to GDP HOUSEHOLD Netherlands – 107% Spain – 84% Italy – 34% CORPORATE 41

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44. Iceland Greece PIIGS United Kingdom Japan United States 44

45. Where Do We Go From Here? Cyclical and Structural Outlook 45

46. Global Economic Recovery Partial Decoupling – China as Driver (India) Strong Monetary Stimulus; Low Interest Rates Strong Fiscal Stimulus; Large Budget Deficits Inflation will appear first at the margin Deflationary Tendencies in Developed World Jobless Recovery Strong Productivity Growth 46 Cyclical Outlook

47. Property Sector, Domestic Debt – China Industrial Overcapacity - China Inflation Interest Rates Japan Europe, PIIGS, UK, (The Euro) Household Debt US Sovereign Debt US (Unfunded Liabilities) Trade Deficit US Unemployment Geopolitical Risk 47 Structural Outlook - Global Risks

48. Low-yield Environment Negative Real Interest Rates Volatility Indexes Low Incentive to Take Risk Options Trading Chasing Yield Chasing Returns “Risk-On” Equity Melt-up Cash Earns Trash 48 Financial Market Environment

49. North vs. South Monetary straightjacket Unable to use currency revaluations to adjust cost structures Productivity ($50.86 vs. $35.80) Finland, Gr, Netherlands in top 10 competitive Inadequate political union German court Karlsruhe Netherlands 49 The Euro Crisis

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