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<ul><li>Section </li></ul><ul><li> </li></ul><ul><li>Credit Markets Today – Where are We? </li></ul><ul><li>Factors Behind the Market – Why is the Market Where it is? </li></ul><ul><li>Outlook - What Happens from Here? </li></ul><ul><li>Opportunities - What Strategies Can be Implemented? </li></ul>Table of Contents
The Market Today – A Leveraged Environment <ul><li>Today’s credit market is marked by high levels of corporate and consumer leverage. </li></ul><ul><li>Consumer borrowing has increased by approximately 72% since 2001 </li></ul><ul><li>Average total corporate debt / EBITDA has increased by approximately 15% over the same period </li></ul>Source: 1 MacroMavens 2 Standard and Poor’s
The Market Today – Historically Tight Spreads <ul><li>Corporate and Emerging Market spreads are currently at historically tight levels </li></ul><ul><li>In addition, certain Emerging Markets currently have deficit current account balances which will have to be funded in the near term, positioning them for a future widening in spreads </li></ul>Source: 1 Standard & Poor’s 2 Bloomberg, as of 4/21/2006 3 International Monetary Fund, as of 12/31/2005 1 -6% 13 Portugal -1.3% 19 Italy -3% 24 Greece -8% 57 Hungary 2% 34 Korea 1% 55 Thailand -5% 5 Spain -11% 26 Iceland Current Account as % of GDP 3 10 Year CDS Spreads 2 Country
Factors Behind the Market – Why is the Market Where it is?
Liquidity in the Market – Transaction Volume Growth <ul><li>There is an unprecedented amount of liquidity in the credit markets despite the rising rate environment. This is evident through the increase in corporate and structured credit transactions in recent years </li></ul><ul><li>Year/year change in corporate debt outstanding has increased from less than 1% in January 2003 to approximately 6% in the end of 2005. 1 </li></ul><ul><li>The total rated volume of U.S. CDO transactions in 2005 was more than 73% larger than transaction volume in 2004. 2 </li></ul><ul><li>ABS issuance increased by 34% to a record $537 billion in 2005. 3 </li></ul>Source: 1 MacroMavens 2,3 Moody’s Investors Service Issuance of Home Equity ABS Corporate Debt Outstanding y/y 0 1 2 3 4 5 6 1/1/03 6/1/03 11/1/03 4/1/04 9/1/04 2/1/05 7/1/05 12/1/05
Liquidity in the Market – The Growth of Money Supply <ul><li>Expanding money supply is a primary source of the liquidity in the market </li></ul><ul><ul><li>Despite Fed’s recent tightening efforts through the raising of rates, liquidity is concurrently being pumped into the market. </li></ul></ul><ul><ul><li>Data shows that while M1 has remained relatively constant and M2 has grown similar to the rate of GDP growth, M3 has shown significant growth rates in recent years. In particular, M3-M2 has grown at a rate of over 15% for each of the past two years. 1 </li></ul></ul><ul><ul><li>Market liquidity has been created through the use of leverage in the form of electronic money (corporate cash, Eurodollars and repurchase agreements) found in the M3 measure of money supply </li></ul></ul>Source: 1 Federal Reserve M3 M2 + Institutional MMKT Funds, Time Deposits > $100K, RPs, Eurodollars M2 M1 + Savings Deposits, Time Deposits < $100K, Retail MMKT M1 Currency in Circulation, Demand Deposits, Other Checkable Deposits
Liquidity in the Market – Foreign Investing <ul><li>Increased foreign buying has also contributed to the market’s liquidity </li></ul><ul><ul><li>Foreign investment in US financial assets has exhibit continuous positive growth over the past 15 years. </li></ul></ul><ul><ul><li>Foreign investing grew by 17.3% in 2004 and 13.4% in 2005 which accounted for approximately 75% of U.S. debt issuance in 2005. 1 </li></ul></ul><ul><ul><li>US Current Account Deficit is running at 7% of GDP (annualized). Foreigners need to put 2.5 billion per day into the US economy to sustain current dollar levels. 2 </li></ul></ul>Source: 1 Federal Reserve, Flow of Funds 2 National Bank Financial
<ul><li>Historically, the end of Fed tightening periods has prompted wider spreads in the credit markets </li></ul><ul><li>In the last 3 periods of rate hikes, BAA rated corporate spreads widened by an average of 70 bps and MBS spreads widened by an average of 33 bps within one year after the Fed stopped raising rates. 1 </li></ul><ul><li>In addition, these periods are characterized by declines in the equity markets. In the last 12 periods of rate hikes the market declined 10 times following the last increase with the average decline amounting to 22% over the next 10 months. 2 </li></ul>Market Outlook – A Widening Spread Environment Source: 1 MacroMavens 2 Comstock Partners, Inc. Market Trends During Periods of Fed Tightening (Shaded) 260 240 220 200 180 160 140 120 100 80 60
Opportunities – What Strategies Can be Implemented?
Opportunities in the Current Credit Markets – Defensive Strategies Source: 1 Credit Suisse MBS are at 5-year cheaps vs. corporates 1 <ul><li>Expect pockets of deterioration among sub-prime borrowers poorly positioned for a decline in bank liquidity and an increase in interest rates and borrowing costs. </li></ul><ul><li>Many sectors of corporate and consumer credit are overpriced and offer “short” opportunities. </li></ul><ul><li>The chart below demonstrates the relative overpricing of corporate credit compared to MBS. Opportunity exists to short corporate credits against long positions in low volatility prime borrower backed MBS that are defensively positioned in the current market. </li></ul>
Opportunities in the Current Credit Markets – “Credit Neutral” Approach <ul><li>Expect current sub-prime production to mirror that of 2000-2001. </li></ul><ul><li>The charts below demonstrate that cumulative loss for prime borrower and Alt-A RMBS reaches a maximum of 0.25% and 1% respectively while sub-prime RMBS credits reach loss levels of up to 6% for vintages of 2000 through 2005. </li></ul><ul><li>In light of these conditions, opportunities exist in defensive strategies involving long positions in prime borrower backed RMBS securities and short positions in mezzanine RMBS floaters backed by sub-prime borrowers, investment grade corporates and sovereign credits. </li></ul>Source: 1 Fitch
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