Greece: Containing “the Contagion”

Assessing the Rapid Escalation of the Sovereign Credit Crisis

May 2010

Tom Joyce Jay Anderson

Debt Capital Markets Strategist Debt Capital Markets
(212) 250 - 8754 (212) 250 - 5741
Tom.joyce@db.com Jay.anderson@db.com

Deutsche Bank Securities Inc., a subsidiary of Deutsche Bank AG, conducts investment banking and
securities activities in the United States.
 Containing “the Contagion”

"A continental currency, with a dual metallic and fiduciary base, resting on all
Europe as its capital, and driven by the activity of 200 million men: this one
currency would replace and bring down all the absurd varieties of money that
exist today with their effigies of princes, those symbols of misery.“
- Victor Hugo (1855)

“Every once in a while, the world is faced with a major economic development that
is ill-understood at first and dismissed as of limited relevance, and which then
catches governments, companies and households unawares.”

~ Mohamed El-Erian, PIMCO (February, 2010)

“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)

2
Contents

1. Week of May 3: Failure to Contain the Contagion

2. May 9th: The €750 billion / US$1 Trillion Stabilization Plan

3. Focus on Greece:
A. The Problem

B. Potential Solutions

4. The Global “Contagion”

A. The “Peripherals”

B. The European Financial System

Appendix

A. Why the Greece Crisis Accelerated Sharply After March 25th?

Week of May 3:
Failure to Contain the Contagion
Section 1
 Global Equity Markets Plunge (Week of May 3rd)
Monday Tuesday Wednesday Thursday Friday Weekly
May 3 May 4 May 5 May 6 May 7 Change

FTSE 100 Index Closed

-2.56% -1.28% -3.20% -2.62% -8.81%

0.51%

DAX Index

-2.60% -0.81% -0.84% -3.27% -6.86%

0.30%

CAC 40

-3.64% -1.44% -2.20% -4.60% -11.12%

Nikkei 225 Closed Closed Closed

-3.27% -3.10% -7.18%

Hang Seng Index

-1.41% -0.23% -2.10% -0.96% -1.06% -5.63%

1.30%

Dow Jones

-2.02% -0.54% -3.20% -1.33% -5.71%

Source: Deutsche Bank Global Markets Research 5

 Euro Drops Sharply to 1.25
There have been EUR / USD Spot (Jan 1, 2010 – Present)
times during the
escalation of the  The Euro collapsed sharply during the week of May 3rd, dipping to 1.2529 on Thursday, May
Sovereign crisis 6, its lowest point since March 5, 2009
where the Euro has
 Rallied back above 1.27 on Friday, May 7
been remarkably
resilient…
1.45
…to be sure, this
resilience broke
down during the May 6 Low: 1.2529
week of May 3rd

1.40
Euro / US$

1.35

1.30

1.25
1-Jan 13-Jan 25-Jan 6-Feb 18-Feb 2-Mar 14-Mar 26-Mar 7-Apr 19-Apr 1-May

Source: Deutsche Bank Global Markets Research 6

 Significant Stress in the Banking System
Perhaps the most 3m EURIBOR / OIS Spreads Since March 25 (September 2010 Contract)
serious global
market impact of the  The 3M EURIBOR-OIS spreads was in excess of May 7 Close: 45 bps
escalating Greek
350 bps at the peak of the financial crisis in Q4,
credit crisis was felt
2008
in the global
banking system as 45  The sharp rise over the week of May 3rd, in
inter-bank lending particular, signals a renewal of stress in the
rates spiked sharply banking system, albeit not yet nearly as high as
over the week of 40 in 2008 (still less than 20 bps)
May 3rd

35
B ps

30

25

20

15
25-Mar 30-Mar 4-Apr 9-Apr 14-Apr 19-Apr 24-Apr 29-Apr 4-May

Euribor - OIS spread

Source: Deutsche Bank Global Markets Research 7

 VIX Volatility Index Leaps 85%
VIX Daily Closing Values (Jan 1, 2010 to Present)
We expect the
highly levered  During the week of May 3rd, the VIX jumped a breathtaking 85%, as investors rapidly re-priced
Western economies risk and embarked on a massive “flight to quality”
(Europe + UK + the
U.S.) to be a primary  In addition to re-pricing risk, and seeking safe haven investments, investors continued their
source of global focus on “the weakest links” in the system
market volatility
over the next few 35
years May 7 Close: 33.8
33
This increased
volatility is likely to 31
be particularly
acute, episodically, 29
throughout the
remainder of 2010
27

25

23

21

19

17

15
4‐Jan 17‐Jan 30‐Jan 12‐Feb 25‐Feb 10‐Mar 23‐Mar 5‐Apr 18‐Apr 1‐May

Source: Deutsche Bank Global Markets Research 8

 US Dollar Credit Spreads Somewhat Resilient
Credit spreads typically US$ Financials Credit Spreads Since March 25
perform poorly when
volatility is high, as was  U.S. financial spreads, especially banks, will be more vulnerable than U.S. corporates

Spread to ASW (bps)

the case during the 480
week of May 3 430
380
New issue volume in the
330
IG bond market was
also its lowest since 280
Sept 2008 (US$450 230
million) 180
130
80
Key Takeaways 1-Jan 26-Jan 20-Feb 17-Mar 11-Apr 6-May
for US$ Issuers
iBx $Dom Fin AA iBx $Dom Fin A iBx $Dom Fin BBB

 Pre-fund!!! US$ Corporates Credit Spreads Since March 25

 More execution risk 250

225
 High volatility
Spread to ASW (bps)

200
 Higher new issue
175
premiums (15 bps+)
150
 Less liquidity
125

 Wider spreads 100

75
 Tighter US Treasury
1-Jan 26-Jan 20-Feb 17-Mar 11-Apr 6-May
Yields
iBx $Dom Corp AA iBx $Dom Corp A iBx $Dom Corp BBB

9
Source: Deutsche Bank Global Markets Research
 Euro & Sterling Credit Spreads More Volatile
Euro and Sterling Financial Credit Spreads Since March 25
Euro and Sterling
credit spread 550 500
volatility has been 500
450
markedly higher 450
400

Spread to ASW (bps)

than in the US$ 400
Spread to ASW (bps)

market, and with 350 350

substantively less 300
300
liquidity, as the 250
sovereign credit 200 250
crisis has escalated 150
200
in 2010 100
50 150
Similar to the U.S. 1-Jan 26-Jan 20-Feb 17-Mar 11-Apr 6-May 1-Jan 26-Jan 20-Feb 17-Mar 11-Apr
market, spreads iBx € Fin AA iBx € Fin A iBx € Fin BBB iBx £ Fin AA iBx £ Fin A iBx £ Fin BBB
performed poorly as
volatility increased

This has been Euro and Sterling Corporate Credit Spreads Since March 25
especially true 350
among European 225
financial names 200 300

Spread to ASW (bps)

175
Spread to ASW (bps)

250
150

125 200
100
150
75

50 100
Source: Deutsche Bank Global
Markets Research 1-Jan 26-Jan 20-Feb 17-Mar 11-Apr 6-May 1-Jan 26-Jan 20-Feb 17-Mar 11-Apr 6-May
iBx € Corp AA iBx € Corp A iBx € Corp BBB iBx £ Corp AA iBx £ Corp A iBx £ Corp BBB
10
 Investor Asset Allocations in “Flight to Quality”
Flight to Quality After March 25, 2010
 Market re-pricing of risk picked up pace after March 25th, in particular
 Recognition that the core cause of the financial crisis has still not been resolved; that is, leverage
 Strong asset allocation shifts:
 Out of: Equities, Commodities and Euros
 Into: Bonds, US Treasuries, US Dollar and Gold

10yr UST Yields Gold (US$ per oz.)

 US 10 Yr Treasuries closed at a 3.43% yield on May 7, its  Gold posted its 3rd straight week of gains on May 7th, a
biggest 2 week drop since December 2008 (38 bps) reflection of its safe-haven appeal
 The Treasury will auction US$78 billion the wk of May 10

4
1210

3.9 May 7 Close: $1,206.68

1190

3.8 1170

3.7 1150

3.6 1130

3.5 1110
May 7 Close: 3.425%
3.4 1090

3.3 1070
25‐Mar 1‐Apr 8‐Apr 15‐Apr 22‐Apr 29‐Apr 6‐May 25‐Mar 1‐Apr 8‐Apr 15‐Apr 22‐Apr 29‐Apr 6‐May

Gold 
10yr UST yield

Source: Deutsche Bank Global Markets Research 11

May 9th:
The €750 Billion / US$1 Trillion Stabilization Plan
Section 2
 Overview of May 9th Stabilization Announcement
On Sunday, May 9th,
the European
Union (and the
IMF/ ECB)
announced a
massive EUR 750
The European Union / IMF The European Central Bank (ECB)
billion policy
response to the
European Size Initiative
sovereign credit
crisis € 60 billion  EU emergency balance of  New “Securities Markets Program” to
payments facility purchase private securities
To be sure, the sheer
size of the plan  Additional size to a pre-  Size and details still TBD
(nearly US$1 existing €50 billion  Expected to be sovereign debt purchases
trillion) eclipsed facility
the U.S. TARP € 440 billion  3 year EU loan program
capital injections  Expansion of ECB refi liquidity facilities
guaranteed by Euro-zone
of $700 billion by a
members  Resumption of full-allotment on 3 month
wide margin LTROs on May 26 and June 30
 Via a special purpose
For many market vehicle (SPV), that will  Resumption of 6 month LTRO on May 12
observers, a possibly issue securities (6 month and 1 year previously
pattern of to fund discontinued)
increased moral
hazard in global € 250 billion  IMF Loans (expected to be  Reactivation of US Dollar swap facilities
financial markets at least 50% of total EU with the U.S. Federal Reserve
has been escalated contribution, but still TBD)  Ensures access to U.S. dollar funds for
European banks to fund U.S. dollar
€ 750 billion assets
 Highly effective facility during the financial
crisis; had been discontinued in Feb 2010
Source: Deutsche Bank Global Markets Research 13
 Breaking Down the €750 Billion EU / IMF Response

Balance of Payments Facility EU Loan Program IMF Loans

Size  € 60 billion  € 440 billion  € 250 billion (expected)

Additional  Can be done quickly and easily  Will require EU member state  Exact size still TBD, but
Detail approval expected to be at least 50% of
 Expansion of a pre-existing €50
billion facility to €110 billion  Given this risk, the total EU contribution

 Previously used to provide concurrent ECB  Unprecedented size for IMF

€750 billion is assistance to Hungary, purchase announcement  As of Feb 2010, IMF had
sufficient in size Latvia and Romania in was critical for the total outstanding
to cover the 2008 market commitments of US$ 191
entire financing  Restriction on further Euro-  Provides the bulk of the total billion
needs (maturities zone use was lifted, and its €750 billion package  Clearly indicates their view
+ deficits) of size expanded  Intended as a “complement” to of Europe’s impact on the
Greece, Ireland, the Balance of Payments facility total global economy
Italy, Portugal  Activation will be subject to
strong conditionality (IMF-like  3 year loans
and Spain until
March 2012 terms)  Funded and guaranteed by Euro-
 Previously financed by European zone member countries on a pro
Commission bond issuance, rata basis (ECB paid in capital)
backed by 27 member states  The UK opted out
 No funding details for new SPV
provided, but is expected to
issue its own securities

Source: Deutsche Bank Global Markets Research. Credit Sights (May 2010). 14
 Breaking Down the ECB’s Response

Securities Market Expansion of ECB Reactivation of US$

Purchase Program Refi Liquidity Facilities Swap Facilities
The ECB’s role was a
particularly  Size to be determined by the  Return to full allotment at fixed  Re-activated with the U.S.
interesting part of ECB Governing Council rate for its next two 3 Month long Federal Reserve, Bank of
the package…  Given ECB sensitivity to inflation, term financing operations England, Swiss National Bank,
purchases will be “sterilized” so (LTRO) scheduled for May 26 Bank of Canada and Bank of
…and its decision to that total money supply does not and June 30 Japan
actively purchase grow  Resumption of 6 Month LTRO  Foreign Central Banks ship
sovereign debt (previously discontinued) on May US dollars to ECB via
 Sterilization mechanism
securities, 12 currency swaps
unclear (offsetting sales of
although perhaps
assets or other “fine tuning”  Will alleviate refi fears on  ECB then lends US$ to EU
anticipated, was by
operations) the July expiry of the banks to fund their US$
no means widely
 Possible sale of €52 billion “jumbo” 12 month LTRO assets
expected
of recently purchased from June 2009  Very successful program
To be sure, the covered bonds  Provides much needed longer during the Financial Crisis
independence and  Some view true ECB term LTRO liquidity, and (Peak usage with U.S. Fed of
reputation of the Quantitative Easing (without eliminates some of the auction US$583 billion in December
ECB will continue offsets) as just a matter of risk for participating banks 2008)
to be a key focus time (because of full allotment)  Terminated in Feb 2010
of the market, and  Purchases began on prior to May 9th reactivation
moral hazard  Mitigates some of the risk of US$
Monday, May 10th
concerns will be investors potentially being
increasingly raised  Given the approval risk on the unwilling to roll-over dollar
over time EU €440 billion loan facility,
this program was very denominate Euro-area bank debt
important to the market

The new ECB measures should take significant pressure off the European banking system

Source: Deutsche Bank Global Markets Research. CreditSights (May 2010). 15

 May 10th Market Response
Global Equity Markets Fixed Income / Currency Markets
Following the €750
billion rescue Market May 10th Response Market May 10th Response
package, global
markets rallied FTSE 100 Index EUR / USD • Close: Unchanged
sharply on May + 5.16% • Intra-day: Volatile swings
10th as investor
risk appetite
returned DAX Index VIX Volatility
+ 5.30% 28%
Index

Notable CAC 40 3M EURIBOR-OIS

Developments + 9.66% 30%
(Sept ’10 Contract)

 The sheer speed and

magnitude of recent IBEX 35 10 Year UST Yields 12 bps
+ 14.40%
market moves (very
HIGH market volatility
continues)
Hang Seng Gold (US$ per oz) 2.1%
+ 2.54%
 On May 10th
specifically, the initial
sharp rise of Euro from Nikkei 225 + 1.60% Greece CDS 280 bps
1.27 to 1.31 intra-day,
only to close at 1.27
later in the day DOW Jones Greece 2 year bond
+ 3.90% 1,073 bps
yield

The May 10th rally was particularly strong among European banks and financials, with
bank equities up over 14%, and bank credit spreads tightening 60 bps on the day
 May 10th Market Response
Both the VIX and
LIBOR-OIS VIX Volatility Index (March 25 – May 10, 2010) EURIBOR – OIS (March 25 – May 10, 2010)
spreads tightened
sharply in the first
24 hours following 42 45 May 7: 44.5 bps
the new EUR 750 May 7: 41
billion EU / IMF / 39
ECB rescue
package 40
36

Nonetheless, we
expect volatility to 33
35
continue to be a
dominant theme in 30 May 10: 30
the 2010 capital May 10: 31 bps

Bps
markets due in 27 30
large part to
continued 24
sovereign credit
risk issues 25
21

18
20

15

12 15
25-Mar 4-Apr 14-Apr 24-Apr 4-May 25-Mar 4-Apr 14-Apr 24-Apr 4-May
VIX Index Euribor - OIS spread

Source: Bloomberg 17
 Looking Ahead: Will this Work?
Assessment of Forward-Looking Risks

Near Term  The EU actions on May 9th were very clearly targeted at sharply reducing 2 risks in particular:
 Contagion risk: both to countries (Portugal / Spain), and capital markets
 Bank-sector funding risk: provide much needed relief to stress build-up in banking system

Long Term  However, several critical risks remain longer-term:

 Insolvency risk: continued high public and private debt levels in Europe
 Implementation risk: on aggressive fiscal austerity programs
For now, any risk of
sovereign debt  Restructuring risk: has it been eliminated, or merely pushed further into the future?
restructurings have  Economic risk: tight austerity measures impact on EU GDP; double-dip recession risk?
likely been pushed out
to beyond the 3 year  ECB Balance Sheet risk: impact on ECB “independence” and decision-making going forward?
term of the new Constrained counterparties will continue to post “the worst” collateral to the ECB?
European Stabilization  Rating Agency Risk: impact of further downgrades, if any, to non-investment grade status
Fund, UNLESS a
specific sovereign falls
 Longer Term Bank Sector Risk: longer term exposure of European financial system to above
significantly short on  Volatility / Confidence Risk: will continue to be very high in 2010
its fiscal austerity  Unintended Consequences?
targets over the interim
time period  Markets in 2010 will continue to test the will of the EU / ECB (and member states) on how to
deal with the enormous existing debt burdens

“Sovereign risk hasn’t gone away in the slightest. What this package has done is
massively reduced the tail risk in European markets without necessarily changing the
medium-to-longer term dynamics of financial markets.”

~ Jim Reid, Deutsche Bank Macro Strategist (May 10, 2010)

Source: Deutsche Bank Global Markets Research. CreditSights (May 2010). 18

Focus on Greece
Section 3
The Problem
Section A
 Greece’s 4 Part Problem
Greece has the most 4 Primary Problems
acute and complex
sovereign debt Problem Consideration
problem in the
European Union…
#1: Credibility Problem  Restated budget deficits each of last 10 years; 4x in 2009 alone
…and is currently the
primary driver of #2: Liquidity Problem  Largely addressed through record EU / IMF bailout packages
“contagion” risk
across the global
economy and #3: Insolvency Problem  The market took little comfort from a EUR 110 billion EU/
capital markets IMF Greek rescue as it focused on this core long-term issue
#4: Banking System Problem  Came under intense pressure week of May 3; ratings
downgrades; decline in confidence; rapidly rising LIBOR

4 Primary Risks

Risk Consideration

#1: Socio - Political Risk  Limited social acceptance of fiscal reforms;

 “All sovereign crises are political crises”
#2: Implementation Risk  Aggressive fiscal targets, monitored quarterly, for next 4 years

#3: Debt Restructuring Risk  Market currently focused on when, not if? Size of haircut will be
the pivotal issue for the European financial and banking system
#4: Contagion Risk  Spillover to global capital markets; Portugal, Spain & others

Source: Deutsche Bank Markets Research. Mark Wall, DB Chief European Economist. 21
 Problem # 1: Credibility Problem
Greece is highly Sources of Greece’s Credibility Problem
dependent on the
capital markets to
 Inconsistent budget forecasts and revisions
solve its liquidity 2009 Fiscal Deficit Revisions
problem…  Tax system
 Fiscal irregularities
…and to this end,  On April 22, 2010, Greece’s 2009
Greece has a  Overstatement of social security surpluses budget deficit was revised higher for
significant  Incorrect reporting of military expenditures the 4th time, to 13.6%, up from a prior
credibility problem estimate of 12.9%
 Incorrect reporting of healthcare expenditures
that has been  Eurostat indicated that uncertainties
building for many  Treatment of certain EU subsidies as revenue around Greek economic data could
years  Accounting irregularities cause a 5th revision, up to 14.1%
 Derivatives transactions (to mask debt levels)

Greece has habitually Greece’s Budget Deficit / GDP

under-reported the
severity of its '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09
Deficit-to-GDP ratio 0.0%

-2.0%
The deficit limit to be
allowed into the -4.0%
Euro-zone (red
line) is 3% -6.0%

-8.0%

-10.0% Original Revised Greece revised its 2003 budget deficit 5 times

-12.0%
Greece revised its 2009 budget deficit 4 times
-14.0%

Source: Deutsche Bank Markets Research. Moody’s. WSJ. 22

 Problem # 2: Liquidity Problem
Although Greece has Greece’s 2010 Liquidity Needs
lost access to the
capital markets to  Total Debt Outstanding: Nearly US$ 400 billion of total outstanding debt
refinance its
maturities, the EUR  Near-term Maturities: Nearly US$ 73 billion of maturities in 2010 alone
110 billion EU / IMF
rescue package  Capital Markets Access: As of late March, Greece has effectively lost access to the capital markets
announced on May
to refinance its upcoming maturities
2nd will address
Greece’s liquidity
needs for 2010…

…and assuming
Greece hits its Total 2010 Liquidity Needs
fiscal targets, this (Bond Maturities + ST Debt Roll + Fiscal Deficit)
package will be
sufficient to cover 500
(US$ billions)
$445
Greece’s 2011 and 450
2012 liquidity Next Critical Greece
400
needs Maturity Date
350
300 $279

USD bn
 EUR 8.5 billion 10 Year 250
Bond on May 19, 2010 200
150
100 $73
$49 $50
50
0
Portugal Italy Ireland Greece Spain

Critics of the current Greek Government would say that they inherited a significant fiscal
deficit crisis, and in the course of several months, created an unparalleled liquidity crisis.

Source: Fitch, Wall Street Research. US$ values based on 1.36 Euro exchange rate
23
 Problem # 3: Insolvency Problem
Twin deficits are a Assessing Euro Sovereign Risk Through the Lens of Twin Deficits
key determinant
for analyzing  An IMF regression analysis of 24 countries indicates that (i) current account deficits, and (ii)
sovereign credit fiscal deficits, are highly correlated with higher sovereign CDS spreads
risk
 Greece’s Fiscal Deficit: At 13.6% of 2009 GDP, it is the second largest in the European
Union (after Ireland), and well above the 3% limits set by the EU’s Maastricht Treaty in 1992

 Greece’s Current Account Deficit: Peaked in Q3 2008; should be down sharply in 2010 –
2011 with aid packages (but still projected to be negative in 2010)

2010E Current Account Deficit (% of GDP) 2010E Fiscal Deficit (% of GDP)

6 0

4 -2
3% limit set
by EU
2 -4
Maastricht
Treaty

% of GDP
0
% of GDP

-6

-2
-8
-4
-10
-6
-12
-8

Source: Deutsche Bank Global Markets Research. IMF Global Financial Stability Report (April 2010).
 Problem # 4: Banking System Problem
Greece’s Top 4 Banks (Stock Price Performance)
 The Greek Banking System is
currently under significant, Piraeus Bank Alpha Bank
unsustainable pressure 14 14
13 13
12 12
 On May 2nd, after previously 11 11
lowering its collateral standards, 10 10
continued Rating Agency 9 9
8 8
downgrades forced the ECB to
7 7
eliminate its minimum rating 6 6
requirements for Greek bonds 5 5
used as collateral to the ECB 4 4

1‐Sep 12‐Oct 22‐Nov 2‐Jan 12‐Feb 25‐Mar 5‐May 1‐Sep 12‐Oct 22‐Nov 2‐Jan 12‐Feb 25‐Mar 5‐May
Alpha Bank
Piraeus Bank
 On April 7th, Greece’s 4 largest
banks requested access to the
remaining EUR 17 billion of a EFG Eurobank Ergasias National Bank of Greece
total EUR 28 billion state 14
support package established in 13
26
2008 12
11
 Combination of loan 10
22
guarantees and Greek 9
government bonds which the 8 18

banks could use as collateral 7

6 14
for credit lines from the ECB
5
 Prior requests entailed 4 10
preferred stock issuance for 1‐Sep 12‐Oct 22‐Nov 2‐Jan 12‐Feb 25‐Mar 5‐May 1‐Sep 12‐Oct 22‐Nov 2‐Jan 12‐Feb 25‐Mar 5‐May
capital injections EFG Eurobank National Bank of Greece

Source: Deutsche Bank, Bloomberg

 Why the Greek Crisis Accelerated After March 25th?
The Acceleration of the Greek Credit Crisis after March 25th, 2010

Date Key Event

The Greek sovereign
credit crisis began March 25 Joint EU / IMF Commitment Announced with Very Few Details
to accelerate
rapidly after March March 30 Low Demand for Greek 20 Year Bond Re-Opening
25th, 2010
April 7 Top 4 Greek Banks Turn to Government

April 9 Fitch Downgrades Greece to BBB- (Negative Outlook)

April 11 EU / IMF Announce Details of EUR 45 Billion Package

April 19 Volcanic Ash Delays EU/ IMF/ Greece Meetings

April 20 IMF Releases Global Financial Stability Report with Sovereign Warnings

April 22  Eurostat Increases Greek 2009 Budget Deficit (Again) to 13.6%

 Moody's Downgrades Greece to A3 (and Review for Downgrade)

Greek Prime Minister, George Papandreou, formally activates EU / IMF aid

April 23 in a live television address

Pivotal Event April 27 S&P Downgrades Greece to non-investment grade status (BB+)

May 2 EU/IMF announce larger Greek aid package of EUR110 billion (US$146 bn)

On April 27, S&P also forecasted a 30% recovery value for Greek bonds in default, an
estimate S&P is required to make when it downgrades a name to non-investment grade;
Markets reacted very negatively
26
Potential Solutions
Section B
 Step # 1: Address Greece’s Liquidity Problem
As of Friday, May 7th,
Joint EU / IMF Solution (for 2010) Other Options Considered
over 10 EU nations
(including
 Key Details:  Raise debt in capital markets (too little
Germany) had
already received demand for Greek debt; pricing too high)
legislative
 May 2nd, 2010: ~ EUR 110 billion
approval for initial
installments on the (nearly US$ $150 billion)  EU Debt guarantees (violation of EU
EUR 110 billion treaties; difficult precedent)
rescue program for
Greece (EUR 80  May 9th, 2010: Expanded for region
billion from the EU) to ~ EUR 750 billion (nearly US$ $1  EU Bond issuance (reconciliation with EU
trillion) treaties challenging)

As such, the liquidity

risk has essentially  Cost: Approximately 5% (Equal to  Bilateral arrangements (moral hazard
been eliminated on Euribor + 300bps + 100 bps step-up in issues; little German domestic support)
Greece’s closely year 3 + 50 bps service charge)
watched EUR 8.5
billion redemption  Infrastructure advances: not sufficient
obligation on May  Duration: 3 years size
19, 2010

Key Question
 Will Greece meet the aggressive fiscal targets required to ensure
continued future installments on the EUR 110 billion rescue package?

“If I owe you a pound, I have a problem, but if I owe you a million, the problem is yours.”
~ John Maynard Keynes (English Economist, 1883 – 1946)
28
 Step # 2: Decisive ECB Support for Euro Bank System
Possible ECB Actions
Relax Mark-to-Market Margin
Purchase Sovereign Debt Expand Refi Liquidity Facilities
Calls on ECB Collateral
 Status: Announced on May 9th  Status: Unlikely (for now); would  Status: Announced on May 9th
 Investors had been disappointed that put ECB Balance Sheet at risk
Trichet avoided this on May 6th  Banks don’t necessarily have to mark-  Prior facilities (as of May 7):
 Blurs boundary between ECB to-market their government bond
independence and EU sovereigns holdings; however, they must do so if  Unlimited (full allotment basis) and
they use them as collateral to the ECB cheap liquidity via 1W and 1M
 Had been viewed as an option of last tenders
resort  Would reduce bank margin calls and
significantly reduce pressure on the  3M tenders shifted to variable rate,
 Likely to put downward pressure on fixed allotment basis
Euro over time system
 However, would effectively pose  6M and 1Y tenders have been
unsecured lending risk on the ECB discontinued

ECB Benchmark Main Refinancing Rate  Changes as of May 9th:

4.5  Move 3M tenders back to full
 On May 6, the ECB kept rates
allotment basis (avoids over-
4 unchanged at 1%, as expected
bidding problems)
3.5  DB does not expect an ECB to
raise rates before Q1, 2011  Reintroduce long term tenders
Percent (%)

3 (6M)
2.5
2
1.5
1.00%
1
0.5
Jan‐08 May‐08 Sep‐08 Jan‐09 May‐09 Sep‐09 Jan‐10 May‐10

Source: Deutsche Bank Global Markets Research. Soniya Sadeesh, Mohit Kumar, Mark Wall and Gillian Edgeworth 29
 Step # 3: U.S. Federal Reserve Swap Lines to ECB
Renewal of U.S. Federal Reserve Swap Lines to ECB
Description Financial Crisis Precedent

 Origin: US Federal Reserve lending program put in  Program Peak: December 2008 (US$ 583 billion)
place during the 2007 – 2009 Global Financial Crisis  Fed viewed as low risk since its counterparties
 Mechanics: US Fed shipped US dollars overseas were foreign central banks
through currency swaps with foreign central banks  Highly successful program
(ECB, Swiss National Bank, Bank of England)
 Program Discontinued: February 2010 (no longer
 European Central Banks then lent the US dollars to needed)
banks in home countries that required funding for
their US dollar assets  Renewal of Program: Announced on May 9th

 Positive impact on: Would relieve short-term US$ funding pressures only
 No impact on: Non US$ funding needs (Euros); bigger non-bank sovereign
issues; inability of European banks to unload illiquid sovereign debt

LIBOR – OIS Spreads (Sept 2008 – Dec 2009)

400 Fed Balance Sheet Expansion  The 3M Libor-OIS Spread was > 300 bps when the Fed
350 extended its Balance Sheet during the Financial Crisis for
US$ currency swaps to the ECB
3 M Libor - OIS Spread (bps)

300
 Although this metric has risen sharply in recent weeks (~
250 20 bps), it is still well below Dec 2008 peak stress levels
200  The Fed / ECB renewed this facility on May 9th nonetheless,
150 given the rapid escalation of the sovereign crisis
100

50

0
Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09
Source: Deutsche Bank Global Markets Research 30
 Step # 4: Address Long-Term Solvency
Greece’s Fiscal Plan: EUR 4.8 billion (USD 6.5 billion, or 2% of GDP)
On March 3rd,
Greece
announced a more #1: Revenue Raising Initiatives #2: Expenditure Reductions
detailed plan for
achieving its 3 year (EUR 2.4 billion / USD 3.25 billion) (EUR 2.4 billion / US 3.25 billion)
fiscal and growth
 Increase value added tax from 19% to  Reduce public sector wages and
targets
21% pensions (EUR 1.7 billion)

 Excise tax on petrol, alcohol, cigarettes  Reduce size of public investment

and luxury goods programs (EUR 500 million)

 Sale of selected state assets  Reduce education expenditures (EUR 200

million)

*** Implementation Risk on Greece’s Fiscal Plan is Very High ***

The IMF will increase
these fiscal Unprecedented EU Role in Europe
austerity measures  The EU has embarked on a path of not just intensely monitoring Greek policy, but actually steering
in its negotiations Greek policy
with Greece, which
should conclude  Greek interest rate policy: to be determined by the ECB
by May 6th  Greek currency policy: to be determined by the EMU
 Greek fiscal policy: to be (effectively) determined and monitored by the EU & IMF
 Economic policy?
 The IMF will focus on 3 critical areas in its new fiscal austerity demands: labor market reform,
healthcare and pension system reforms

Key Question: How will Greece mitigate the vicious circle of fiscal cuts and economic
slowdown as it strives to meet its 4 Year Stability and Growth Program targets?
31
 Step # 5: Greece Must Meet its Fiscal Targets
Greece’s 4 Year “Growth and Stability Program” Forecasts
In 2010, Greece
needed to tap the Fiscal Deficit Forecast Debt / GDP Forecast
assistance offered
by the EU and IMF (% of GDP)  4 Year Plan to reduce fiscal Debt / GDP will peak in 2011
12.7%
deficit below 3%, in accordance 120.4% 120.6%

To avoid a potential with EU guidelines 117.7%

default, Greece will
have to deliver on 8.1% 113.4% 113.4%
7.6%
its official 4 Year
6.5%
“Stability and
Growth Program” 4.9%
targets
<3%

2009 2010E 2011E 2012E 2013E

2009 2010E 2011E 2012E 2013E 2014E

3.0% Projected GDP Growth Projected Unemployment Rate

2.1% 2.1%
2.0% 10.5% 10.5%
2010 Greece GDP 1.1% 10.3%
Forecasts: 1.0%
9.9%
 EU Forecast: (-4.0%)
0.0%
 DB Forecast: (-4.0%)
-1.0%
9.0%
-2.0%

-3.0% -2.6%

-4.0%
-4.0%
2010E 2011E 2012E 2013E 2014E 2009 2010E 2011E 2012E 2013E
Source: Deutsche Bank Global Markets Research 32
 Critical Step # 6: Potential Debt Restructuring?
A Greece Potential Implication of a Greece Debt Restructuring?
restructuring could
possibly be the  Official EU & Greek Position: Debt restructuring is “off the table”
largest sovereign
default in history  Market Position: Already pricing in either partial reductions, or delays, in Greek debt repayments

 Key Question: If Greece was to “trip” in its fiscal consolidation program, and a restructuring of Greek debt

While the EU is followed, would such a default unfold more aggressively (with the 75% haircuts of Argentina’s precedent), or
calling a debt in a highly managed and orderly fashion (with modest to medium haircuts of < 50%)?
restructuring “off
the table”… Argentina Precedent, 2002 Poland Precedent, early 1990s
(Less controlled; 75% Haircuts) (More Managed; ~ 50% Haircuts)
…many investors are
viewing it as an  Would be a “devastating” event for the  Would be a “significant” event for the
“overwhelming European financial system European financial system
probability”
 Defaults of many creditor institutions  If managed in “orderly” fashion, most
 Massive investor losses and cross-
creditors would avoid default themselves
exposures  However, losses would be significant
 Greek debt / GDP would decline to ~ 30%  Greek Debt / GDP would decline to ~ 60%
Historical Note:
 Would likely trigger a European financial and  Could trigger a European financial crisis, but
banking crisis (and possibly global) should be more contained
Greece’s last
sovereign debt  Analogous to a “Lehman-type” event with full  Range of significant “unintended
default was range of unintended consequences consequences” likely
resolved in the  Confidence in European “peripherals” would  Significant contagion and spill-over effects to
mid-1960s evaporate immediately (significant contagion European peripherals likely
effects to Portugal, Spain, Ireland, Italy and  Significant downward pressure on European
others) growth
 Significant questions for Euro longer term  Significant questions for Euro longer term

Source: Deutsche Bank Markets Research. 33

 Step # 7: Strengthen Long Term Viability of the Euro?
Critical Mechanisms to Ensure Long Term Viability of the Euro
More effective fiscal
monitoring  Bankruptcy regime for failing member states
mechanisms, with
real accountability,  Exit mechanism from EMU for failing member states
will be critical to  Efficient fiscal transfer mechanisms for member states requiring assistance
the long-term
 More effective fiscal monitoring and enforcement mechanisms
viability of the Euro

Many have also EUR / USD Spot (Jan 1, 1999 – Present)

raised the longer
1.7 May 7 Close: 1.2725
term possibility of
EMU membership 1.6
returning to a
1.5
much smaller
group of nations in 1.4
line with its
1.3
original
Euro / US$

construct… 1.2

1.1
…such an unwind
would be 1.0
exceptionally
0.9
difficult to execute,
but should not be 0.8
ruled out as a
0.7
longer term
possibility

Although Europe will not attain the political union so many have cited as critical to monetary union, more
aggressive fiscal enforcement mechanisms will be critical to the long-term viability of the Euro

Source: Deutsche Bank Global Markets Research 34

 Precedent Large IMF Sovereign Bailouts
The IMF EUR 30 Selected Large IMF Bailouts
billion aid to
 IMF aid to Greece will likely be accompanied by aggressive fiscal reforms, particularly:
Greece represents
3200% of Greece’s  Pension reform
official quota, the  Healthcare reform
largest ever such
disbursement of  Labor system reform
IMF aid to any
country
 There has actually been significant precedent for sovereign default, even after IMF aid
120

100

Selected IMF
Sovereign Bailouts
80
that Subsequently
Dollars in billions

Defaulted
60
 Argentina

 Indonesia 40

 Uruguay
20

 Dominican
Republic
0
Greece South Korea Mexico Indonesia Brazil

IMF Share Partners' Contributions
2010 1997 1995 1997 1998
Source: Deutsche Bank Global Markets Research 35
 Who are the Key Players in Europe?

Greece Germany European Union IMF

 Prime
Minister:
George Papandreou
 Finance Minister:
George
Papaconstantinou
 OppositionLeader:
Antonis Samaras
 Currently endorsing
Government plan
 Chancellor: Angela  European Central Bank President: Jean-  Managing Director
Merkel Claude Trichet (President): Dominique
Strauss-Kahn
 FinanceMinister:  European Union President: Herman Van
Wolfgang Schaeuble Rompuy  First
Deputy
Managing Director
 (Rotating)President of EU: Spain (Prime (IMF # 2): John Lipsky
Minister Jose Luis Rodriguez Zapatero)
 European Commission President: Jose
Manuel Barroso (former Prime Minister of
Portugal)

France  Eurogroup Chairman (Chair of Euro-

area Finance Ministers): Jean-Claude
 President: Nicolas Juncker (also Prime Minister of
Sarkozy Luxembourg)
 Finance Minister:  Economic
& Monetary Affairs
Christine Lagarde Commissioner: Olli Rehn

36
The Global “Contagion”
Section 4
A. The Peripherals
 Markets Shifts Focus to “Total Economic Leverage”
Market attention has
shifted toward a Sector Composition of Debt Across Economies
renewed focus on
balance sheet Japan’s sovereign debt, though exceptionally high, has not created a
adjustment crisis because it relies very little on foreign capital markets to refinance

In analyzing leverage
within an Government Nonfinancial business Households Financial institutions
economy, it is very 500
469 459
important to focus The very high private AND public debt in the UK and Spain has increasingly
on where in the 450 become the focus of investors as contagion spreads from Greece
52
economy the debt
resides 400 380
Percent of GDP

188 Greek government debt levels (115% of GDP) were

The market has 114 52 342
350 331 the catalyst for the current sovereign credit crisis
begun to focus not 313
47 28 308
only on sovereign 298 290
300 37
leverage, but on 274
114 73
both public and 60 245 230
250 101 115 101
private sector 75 69
96 136
leverage 60
200
throughout the 78
110
economy 66 115 159
101 81 54
150 80 142
67 118 32 129
85
44 96 62 66
100 202 40
84 71
96
5
108 113 108 30
50 84 42 40
75 81 77 76
56 47
18 11 16
0

*The UK financial sector was adjusted to reflect its position as a financial hub. *Data for Switzerland represent year-end 2007
39
Source: Haver Analytics, FDIC, SNL Financial, Federal Reserve. McKinsey Global Institute. IMF Global Financial Stability Report.
 Sovereign Market Vulnerability Indicators
There are several key Review of Selected Sovereign Vulnerability Indicators
indicators, beyond
the absolute
Depository Bank Claims
amount of Gov't Debt Held Abroad on Government (1)
sovereign debt,
that are critical to Country (% of GDP) (% of GDP)
understanding the
vulnerability of
sovereign leverage Greece 99.0% 17.5%
to an economy
Portugal 60.2% 10.2%
Italy 56.4% 29.4%
For many of these Ireland 47.2% 5.8%
leverage models
to work, capital Spain 26.9% 20.6%
markets must be United States 24.7% 8.2%
open 24 / 7
United Kingdom 17.9% 5.1%
Japan 13.7% 69.3%

According to Ken Rogoff and Carmen

Reinhart in “This Time is Different,” Why is Japan’s High Debt Seemingly Lower Risk?
most emerging market countries
run into trouble at external debt  High domestic savings
levels above 60% of GDP  Low foreign ownership of debt (< 14% of GDP)
 Strong home bias
 Stable institutional investors
 Local banks purchase high % of Govt debt

(i) Source: IMF Global Financial Stability Report (April 2010). Includes all claims of depository institutions, excluding the Central Bank, on the
Government. 40
 The “Contagion Effect” for the Peripherals
Greece continues to “Peripherals” 10 Yr Bond Spread over Germany
be an outlier, but
has clearly had a 9.0
direct impact on
the
8.0 May 7 Close (Greece): + 9.65%
“peripherals”, 7.0

especially over 6.0

the last few
%

5.0
weeks
4.0

The market will 3.0

continue to be 2.0
focused on “the 1.0
weakest links” in
0.0
the system
Oct-07 Mar-08 Aug-08 Jan-09 Jun-09 Nov-09

Greece Ireland Portugal Spain Italy

“Peripherals” CDS Under Pressure

940
880 May 7 Close (Greece): + 938 bps
820
760
700
640
580
520
460
bps

400
340
280
220
Source: Deutsche Bank,
160
Bloomberg
100
40
Jun-09 Jul-09 Aug-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10
41
Portugal Greece Ireland Italy Spain
 The “Ring of Fire”
5 Year CDS Spread Differentiation (As of May 7, 2010)
Given their current
ratings, the
950
European Spread Greece
“peripherals” are 5y CDS (bp)
clearly trading 850
“above the trend
line” from a credit
risk perspective 750
vis-à-vis a very
broad range of
sovereign credits 650
“Ring of Fire”
globally

550

Portugal
450

Lebanon
350 Iceland
Bulgaria
Hungary Kazakhstan Vietnam
250 Uruguay
Spain Italy
Ireland Russia
SOAF
Poland Egypt Turkey,
Israel MX Colombia Philippines
150 Brazil,
Thailand
Belgium Malaysia Peru
Chile
Austria
UK China S. Korea
50
USA, FR

GE
Ratings (avg. of Moody's/S&P)
-50
Aaa Aa2 A1 A3 Baa2 Ba1 Ba3 B2

Source: Deutsche Bank, Bloomberg 42

 2010 - 2011 Peripheral Redemptions (Monthly)

(Euro Billions)

Portugal Bills Bonds Coupon Total Greece Bills Bonds Coupon Total
May-10 1.3 5.9 0.3 7.5 May-10 0.0 8.4 2.2 10.7
Jun-10 1.6 1.6 Jun-10 0.0 0.0 0.0 0.0
Jul-10 3.9 0.0 3.9 Jul-10 2.0 0.0 3.0 5.0
Aug-10 0.0 0.0 Aug-10 0.0 0.0 1.6 1.6
Sep-10 2.2 0.4 2.6 Sep-10 0.0 0.2 0.8 1.0
Oct-10 1.2 1.2 Oct-10 1.3 0.0 1.1 2.4
Nov-10 2.6 0.0 2.6 Nov-10 0.0 0.0 0.0 0.0
Dec-10 0.0 0.0 Dec-10 0.0 0.0 0.1 0.1
Jan-11 1.3 0.0 1.3 Jan-11 1.0 0.0 0.3 1.4
Feb-11 1.8 0.0 1.8 Feb-11 0.0 0.0 0.0 0.0
Mar-11 1.5 0.0 1.5 Mar-11 0.0 9.0 1.9 10.9
Apr-11 5.0 0.7 5.7 Apr-11 0.0 0.0 0.0 0.0
May-11 0.0 0.0 May-11 0.0 6.9 1.7 8.6
Jun-11 6.8 1.6 8.4 Jun-11 0.0 0.0 0.3 0.3
Jul-11 0.0 0.0 Jul-11 0.0 0.0 3.0 3.0
Aug-11 0.0 0.0 Aug-11 0.0 6.0 2.1 8.1
Sep-11 0.4 0.4 Sep-11 0.0 0.0 0.8 0.8
Oct-11 1.2 1.2 Oct-11 0.0 0.0 1.1 1.1
Nov-11 0.0 0.0 Nov-11 0.0 0.0 0.0 0.0
Dec-11 0.0 0.0 Dec-11 0.0 5.8 0.1 5.8

Source: Bloomberg, DB Global Markets Research, Gillian Edgeworth 43

 2010 - 2011 Peripheral Redemptions (Monthly)

(Euro Billions)

Spain Bills Bonds Coupon Total Ireland Bills Bonds Coupon Total
May-10 8.3 0.0 0.0 8.3 May-10 4.2 0.0 4.2
Jun-10 6.5 0.0 0.0 6.5 Jun-10 1.0 0.3 1.3
Jul-10 6.7 17.7 7.3 31.6 Jul-10 2.0 0.0 2.0
Aug-10 5.4 0.0 0.0 5.4 Aug-10 0.0 0.0
Sep-10 4.4 0.0 0.0 4.4 Sep-10 0.0 0.0
Oct-10 4.9 0.0 0.0 5.0 Oct-10 0.4 1.0 1.4
Nov-10 5.5 0.0 2.4 7.9 Nov-10 0.2 0.2
Dec-10 4.6 0.0 0.0 4.6 Dec-10 0.0 0.0
Jan-11 4.5 0.0 5.4 9.9 Jan-11 0.4 0.4
Feb-11 4.0 0.0 0.1 4.1 Feb-11 0.0 0.0
Mar-11 4.7 0.0 0.0 4.7 Mar-11 0.7 0.7
Apr-11 0.0 0.0 0.0 0.0 Apr-11 1.1 1.1
May-11 0.0 0.0 1.7 1.7 May-11 0.0 0.0
Jun-11 0.0 0.0 0.0 0.0 Jun-11 0.3 0.3
Jul-11 0.0 17.0 0.0 17.0 Jul-11 0.0 0.0
Aug-11 2.8 0.0 6.7 9.5 Aug-11 0.0 0.0
Sep-11 0.0 0.0 0.0 0.0 Sep-11 0.0 0.0
Oct-11 0.0 14.1 2.4 16.5 Oct-11 1.0 1.0
Nov-11 0.0 0.0 0.0 0.0 Nov-11 4.4 0.2 4.6
Dec-11 0.0 0.0 0.0 0.0 Dec-11 0.0 0.0

Source: Bloomberg, DB Global Markets Research, Gillian Edgeworth 44

 Focus: Portugal
Key Facts Key Considerations

Historical Note:  Economy Size: US$ 228 billion  Small economy (2% of European GDP)

 Unemployment Rate: 10.1%  Very little economic diversification

Portugal had an
IMF assistance  2010E GDP Growth:
program as  2010E Fiscal Deficit:
recently as 1984
 Debt Outstanding:
 Foreign Ownership
of debt (% of GDP):
0.7%
 Economic competitiveness and productivity growth
( - 8.3%) has been especially weak; no ability to devalue
EUR 191 billion currency to improve competitiveness
 Very high twin deficits (current account and fiscal)
60.2%
 Less public debt than Greece, but still high

 Very high foreign ownership of debt (and so highly

Remaining Redemptions & Coupon Payments (EUR bn) dependent on capital markets)
25  Highly levered private sector as well
19.2 19.6
20  Does not have same market credibility problem as
Greece
14.3
15
11.7  Moved earlier on many of its fiscal austerity
10.5
10 measures

 More implementation risk with minority Government

5

0
2010 2011 2012 2013 2014

Source: DB Global Markets Research. IMF.

 Focus: Spain
Key Facts Key Considerations

 Economy
[TJ – to come]
Size: US$ 1.46 trillion  Large economy (greater potential contagion impact)
Historical Note:
 Unemployment Rate: 20.05%  20% unemployment among highest in Europe
Despite a relatively
better modern  2010E GDP Growth: ( - 0.2%)
 Very weak banking system; real estate crisis was
history, Spain  2010E Fiscal Deficit: ( -10.2%) greater than most European EMU peers
holds a record for
 Debt Outstanding: EUR 560 billion
the most
 One of the most highly levered private sectors in
independent  Foreign Ownership
Europe
sovereign default of debt (% of GDP): 26.9%
episodes (12)
 Weak economic competitiveness; no ability to
devalue currency to increase growth and
competitiveness; labor system reform progress
Remaining Redemptions & Coupon Payments (EUR bn) needed

90 84.2  Very high twin deficits (current account and fiscal),

80 70.8 but manageable
70 65.6
58.5  Better liquidity position than Greece and Portugal
60 52.1 with less dependence on foreign bond ownership;
50 Spanish banks absorb much bond issuance; EUR 40
40 billion to raise by July 2010
30
20
 Does not have same market credibility problem, or
capital market dependence, as Greece
10
0
2010 2011 2012 2013 2014

Source: DB Global Markets Research. IMF. Kenneth Rogoff and Carmen Reinhart: This Time is Different
 Focus: Italy
Key Facts Key Considerations

 Economy
[TJ – to come]
Size: US$ 2.12 trillion  Large economy (greater potential contagion impact)

 Unemployment Rate: 8.2%  More powerful and diversified economic engine, and
 2010E GDP Growth: 0.9% so more ability to grow through debt burden
 2010E Fiscal Deficit: ( - 5.1%)  Strong manufacturing sector has shown
 Debt Outstanding: EUR 1.76 trillion improvement with recent Euro weakness
 Foreign Ownership
 Unemployment rate not as high as many Euro peers
of debt (% of GDP): 56.4%
 Public sovereign debt levels among the highest in
Europe; however, household leverage reasonably
low
Remaining Redemptions & Coupon Payments (EUR bn)
 Very high twin deficits (current account and fiscal)
300
259.7 254.8  Relatively high foreign ownership of debt
250
197.6  Does not have same market credibility problem as
200
Greece
150 135.3 125.4

100

50

0
2010 2011 2012 2013 2014
Source: DB Global Markets Research. IMF.
 Focus: Ireland
Key Facts Key Considerations

 Economy
[TJ – to come]
Size: US$ 223 billion  Small economy (2% of European GDP)

 Unemployment Rate: 13.4%  Likely to outperform other peripheral economies over

 2010E GDP Growth:
 2010E Fiscal Deficit:
 Debt Outstanding:
 Foreign Ownership
of debt (% of GDP):
( - 0.3%) the next 1 – 2 years
( - 10.7%)  Moved early on fiscal austerity measures
EUR 104.7 bn
 Weak banking system with significant exposure still
to real estate crisis; majority Government stake or full
47.2% nationalization of several Irish banks

 Highly levered private sector as well

Remaining Redemptions & Coupon Payments (EUR bn)  Double-digit fiscal deficits
14 12.7  Much less public debt than Greece, but a series of
12 needed bank bailouts have sharply increased public
10.4 debt (90% of GDP by 2013)
10 9.06 9.2
8.1
8  Less dependent on capital markets and foreign
investors than Portugal and Greece
6
 Has suffered from among the highest GDP declines
4
during the Financial Crisis in all of Europe; however,
2 the economy is showing more signs of recovery than
many other peripherals
0
2010 2011 2012 2013 2014

Source: DB Global Markets Research. IMF.

 Focus: United Kingdom
Key Facts UK May 6th Election Results
 Inconclusive, producing first hung Parliament in
 Economy
[TJ – to come]
Size: US$ 2.18 trillion
With the national over 35 years (1974)
elections on May  Unemployment Rate: 8.0%  Conservatives fell 19 votes shy of 326 seats
6th now over, required for majority in 650 seat House of
 2010E GDP Growth: 1.5%
markets and Commons
Rating Agencies  2010E Fiscal Deficit: ( - 11.3%)  Likely minority Government or a coalition
are likely to  Conservative / Liberal deal most likely
 Debt Outstanding: GBP 923 billion
increase the
intensity of their  Foreign Ownership  Likely Prime Minister: David Cameron (Conservative)
focus on the U.K.
of debt (% of GDP): 17.9%  Potential Market Risk: Any significant delays in
forming a new Government, and any subsequent
Any significant delays in implementing fiscal austerity measures
delays in forming a
new Government, GBP / USD Number of Seats in the UK General Election
and any delays in 1.7
implementing
fiscal austerity
measures, could 1.65
350
Required for overall majority (326)
create increased 307
volatility in the 300
258
market
1.6 250
GBPUSD

200
1.55
150

100
1.5 57
50 28
May 7 Close: 1.4788
0
1.45
Conservative  Labour Party Liberal Democrat  Other
May‐09 Aug‐09 Nov‐09 Feb‐10 May‐10
Party Party
Source: DB Global Markets Research. IMF.
 Focus: United Kingdom
United Kingdom Credit Risk

Positives Considerations

 Larger, more diversified economy than the  Significant private sector leverage (consumer, financial
The UK has several peripherals and corporate debt among highest in Europe)
key advantages  Sovereign debt rapidly rising toward 90% of GDP by
over “the  Ability to devalue its currency to increase
competitiveness (and inflate through debt) end of 2010
peripherals” in
managing the  Less coordination to implement fiscal cuts  Financial sector/ banks still weak from Financial Crisis
leverage in its  “Flight to quality” at times of peak stress  High exposure to the “peripherals”
economy…
 Strong access to capital markets
…and several very
substantive UK Bond Yields Over Germany Net Notional UK CDS
weaknesses
110 8,500
May 7 Close: 103bps
8,000

100 7,500
Evidence of More UK
Investor Concern 7,000 UK CDS Net 
90 Notional Amt 
Spread to Bunds (bps)

US Dollars (billions)
 Doubling in UK CDS 6,500
outstanding
80 6,000
 Rising UK bond yields
5,500
 Sterling weakness 70
5,000

4,500
60
4,000

50 3,500
Jan‐10 Feb‐10 Mar‐10 Apr‐10 May‐10 Jan‐10 Feb‐10 Mar‐10 Apr‐10
Source: DB Global Markets Research
 Recent Downgrades “Feeding the Contagion”

Rating Recent Action Rating Recent Action Rating Recent Action

Negative outlook in Sep '09 2 notch downgrade in 1 notch downgrade in

Aa2 (Neg) A- (Neg) AA- (Neg)
Review for negative outlook May '10 Apr '10 Mar '09

Portugal

1 notch downgrade in 1 notch downgrade in

Aa1 (Neg) 1 notch downgrade in Jul '09 AA (Neg) AA- (Stable)
Jun '09 Nov '09

Ireland

3 notch downgrade in 2 notch downgrade in

A3 (Neg) 1 notch downgrade in Apr '10 BB+ (Neg) BBB- (Neg)
Apr '10 Apr '10

Greece

1 notch downgrade in
Aaa (Stable) n/a AA (Neg) AAA (Stable) n/a
Apr '10

Spain

 On April 27th, S&P downgraded Greece from BBB+ to BB+, making Greece the first EU nation to be rated
non-investment grade (and also warned investors could recover as little as 30% on a restructuring)
 Recent downgrades of Greece, Spain and Portugal (including both the sovereign and selected banks) have
demonstrated how ratings can become a loose cannon as the Sovereign Crisis unfolds

Source: Bloomberg 51
 Rating Downgrades Impact on Banking System
Systemic Impact of Ratings Downgrades on the European Banking System

Drivers of Bank Pressure Signs of Bank Pressure

The recent sovereign
ratings  As sovereign funding increases, bank
downgrades have funding costs will also increase  Bank equities under-performing
put an enormous
amount of
systemic pressure  Mark-to-market impact of government bond  Libor/ Euribor levels have
on the European holdings for banks increased
banking system  Likely to be limited
 Most German and French banks, for  Libor / OIS spreads have widened
example, carry government bonds at face
value (held to maturity book) rather than
market value  Swap spreads have widened

 Margin calls due to falling value of  EUR / USD cross currency basis
government bonds used as collateral in has widened
repo operations with (i) other banks; and
(ii) central banks
 Greek banks were funding EUR 61 billion
via the ECB through Repo
 A 10% increase in 2 year yields on Greek  These stresses in the banking sector
bonds since February, for example, would make the current situation
require Greek banks to post an additional unsustainable for the ECB
 Must either ease current collateral
20% of collateral, or EUR 12 billion
standards or risk triggering a liquidity
crisis for banks)

Source: Deutsche Bank Global Markets Research. Mohit Kumar and Abhishek Singhania.
C. The European Financial System
Section
 Ownership of Greek Government Bonds
Ownership of Greek Government Bonds (2009)
The European  Total Greek Government Debt: EUR 273 billion (2009)
financial system has
most of the
exposure to Greek  Domestic (Greek) Ownership: EUR 59 billion (EUR 44 billion banks; EUR 15 billion “Other”)
Government bonds
(banks, pension
funds and investors)  Foreign Ownership: EUR 214 billion (EUR 75 billion banks; EUR 139 billion “Other”)
 “Other” comprised largely of European fund managers, pension funds and insurance
 U.S. ownership (3%) and Asia ownership (2%) is de minimus

By Owner Type (2005 – 2009) By Country Region

Central Banks /  Other, 4% USA, 3% Asia, 2% Spain/Portugal, 

Sovereigns, 5% Scandinavia, 3% 1%
Hedge Funds,  Other, 6%
5%
Asset 
Management,  Benelux, 6% Greece, 29%
10% Banks & Trusts, 
45% Italy, 6%

Insurance / 
Pension Funds,  Germany/Switz
14% erland/Austria, 
9%
France, 11% UK/Ireland, 
Fund Managers,  23%
19%

Source: Deutsche Bank Global Markets Research, Gillian Edgeworth, Greek Public Debt Management Agency.
Institute of International Finance (IIF) 54
 Foreign Claims: Who do the Peripherals Owe Money To?

(US$ Billions) Breakdown of Ownership

Total Foreign  European 
Claims Austria Belgium France Germany Ireland Italy Netherlands Portugal Spain Sweden Switzerland UK US Banks

303 6 8 75 43 9 8 12 10 1 1 64 12 16 253

939 9 72 78 193 23 34 22 16 6 18 193 74 692

1463 21 50 494 209 47 78 6 51 4 22 76 61 1072

287 3 9 36 47 6 7 12 89 1 4 25 6 239

1154 9 46 196 240 32 31 127 29 6 14 119 53 868

3809 27 108 389 503 233 57 207 13 393 40 238 550 2304

Source: Deutsche Bank Global Markets Research, Gillian Edgeworth, BIS 55

 Massive Exposure for European Banks
European Banks may Sources of European Bank Exposures
represent the most
significant channel Asset Side Liabilities Side
for “contagion”
from the sovereign  Losses on government bond portfolios  Higher bank funding costs, and less financing
credit crisis  Losses on loan portfolios (cross-border, local)
market access (less demand, more volatility)
 Erosion in perceived value of Government
 Counterparty exposures on derivatives
guarantees
 Generally, bank business models highly
 Ratings downgrades can drive higher haircuts
susceptible to economic slowdowns and market
instability on government securities used for central bank
or commercial repo

Sources of contagion: Higher losses; difficult financing markets; less lending

European Bank Exposure to Eurozone Governments (December 2009)

900 $849
Holdings of Eurozone Government Debt
$767
800
Loans to Euro Governments
700 $622
360
600
496
USD billion

500
284
400 $329
300
488 $185 $173
200 242
337
271 112
100 158
87 61
0 27
German Banks French Banks Italian Banks Spanish Banks Belgian Banks Dutch Banks

Source: Autonomous, February 8, 2010. Based on Euro Exchange Rate of 1.36 56

 Less Exposure for U.S. Banks
Implications for U.S. Banks
Direct exposure of
the U.S. banking  Direct Losses from Lending / Derivatives: limited, especially compared to European banks
system to over-  The U.S. banking system relies very little on overseas earnings (< 20%)
indebted European
 Tier 1 capital is well in excess of direct exposures
sovereign credits
is reasonably
limited…  However, indirect impact of an escalating crisis could be significant:
 Bank spreads are particularly vulnerable to exogenous shocks in the global financial system
…but the indirect
impact of  Negative impact on lending and bank facilities
“contagion”  Contagion through increased systemic risk
effects on a  Heightens focus on financial regulation (with upward pressure on capital, and downward pressure on
vulnerable global earnings)
financial system
could be
substantive Claims on Sovereigns Held by U.S. Banks (1) Aggregate U.S. Bank Exposure vs. Top 10 U.S.
(September 2009) Bank Capital
90 $82 900 $850
80 Total: $178 billion 800
$68
70 700
60 600
USD bn

USD bn
50 500
40 400
30 300
$18 $178
20 200
$9
10 100

0 0
Ireland Spain Greece Portugal Aggregate exposure to Top 10 US bank
Greece, Ireland, Portugal, Tier 1 capital
Ireland Spain Greece Portugal and Spain

Source: Federal Financial Institutions Examination Council.

(1) Claims consist of cross-border loans, claims from derivatives, and foreign office claims on local residents 57
Why the Greece Sovereign Credit Crisis
Accelerated Sharply After March 25th?
Appendix A
 March 25: Joint EU / IMF Package with Few Details
On March 25th, the Overview of March 25th Joint EU / IMF Package
European Council
met in Brussels for
their quarterly Announced Details The Missing Details?
summit meeting
and agreed on a  Joint EU / IMF package of loans  Exact size of the package
rescue package of  IMF involvement is “substantial”
“last resort” that  Euro countries “expected” to pay based  Exact cost
would involve both
on their capital weights
the IMF and the EU
 Duration of the loans
By involving the IMF  Tough conditionality
in the solution  “Last resort” only (not a freely available  Duration of the package
already, the EU backstop facility)
essentially cut off  IMF not part of decision for its use  Exact role of IMF
Greece’s other key  Requires unanimous 27 nation support
option, and  Distribution of funds?
Germany, in  Not cheap  Technical assistance?
particular,  “Risk adequate pricing” that will  Enforcement power / set conditions?
increased its encourage Greece to return to market for
leverage over the
financing
process
*** Over subsequent weeks, Investors reacted
 Required review of EU budget rules very negatively to the lack of detail ***
 Proposals due by year-end
 Tougher budget rules
 More flexibility for crisis response

The sharp acceleration of the Greek credit crisis began on March 25th, when the EU and IMF
announced a “joint-rescue package” with very few details; uncertainty and volatility followed

Source: Mark Wall, DB Chief European Economist. Deutsche Bank Markets Research. 59
 March 30: Low Demand For Bond Re-opening
March 29: EUR 5 Billion New Issue March 30: EUR 390 Billion Re-Opening
 New Issue: 7 Year bond raising EUR 5 billion  Re-opening: EUR 390 million re-opening of 20
at mid swaps + 310 bps, or ~ 6% YTM year 2022 bond on March 30, 2010

 Demand: Over EUR 6.25 billion from 175 +  Demand: Greece had initially hoped to re-open
accounts (10 year bond earlier in year had this 20 year bond for EUR 1 billion, but demand
EUR 16 billion demand from 400 + accounts) was not sufficient

 After-market performance: Immediately *** The poor performance of Greece’s Mar 29th 7 year bond,
sold-off in after-markets; negatively impacted and low demand for its March 30th 20 year re-opening,
demand for March 30 re-opening signaled limited Greek access to public debt markets

After-market Performance of Greece’s March 29th 7 Year EUR 5 Billion Bond Deal
9.5

9 Greece’s 7 year EUR 5 billion new issue on March

29th immediately sold-off in secondary markets
8.5
Yield (%)

7.5

6.5

6
30‐Mar 3‐Apr 7‐Apr 11‐Apr 15‐Apr 19‐Apr 23‐Apr
GGB 5.9% '17s
Source: Deutsche Bank, Bloomberg (GGB, Corp). 60
 April 9: Fitch Downgrades Greece to BBB- (Neg)
Review of Fitch Downgrade

On April 9th, Fitch  Downgrade: Greece’s Long Term foreign and local currency Issuer Default Ratings downgraded
Ratings to BBB- from BBB+, Outlook Negative
downgraded
Greece from BBB+
to BBB-, Outlook  Drivers of the Downgrade:
Negative  Fiscal challenge increases
 More adverse prospects for economic growth
 Increased interest costs
 Ongoing uncertainties on the Government’s financing strategy amidst market volatility

“The sharp rise in interest rates faced by the government this year, in
combination with a deterioration in the outlook for economic growth, will
make it harder for the government to achieve its fiscal targets of reducing the
deficit to 8.7% of GDP this year and ensuring that public debt peaks at just
over 120% of GDP in 2010 and 2011.”
- Fitch Ratings (April 9, 2010)

Source: Fitch Ratings. 61

 April 11: EU / IMF Announce EUR45 Billion Package
On Sunday, April 11th, Overview EU Member Contributions
following nearly 3  Contributions by each EU member based on each
weeks of sharp  Size: ~ EUR 45 billion (US$ 60 billion) country’s capital weight at the ECB
deterioration in
 EUR 30 billion from Euro nations
market conditions
for Greece since (commitment) EMU Contributions Based on ECB Capital Weights
the March 25th  Additional EUR 10 - 15 billion from Implied Share of
announcement, the IMF (expected) Capital Weight EUR 30 bn (EUR
EU and IMF finally Country at ECB (%) bn)
announced a more
 Cost: Approximately 5%
detailed package
 Equal to Euribor + 300bps + 100 bps 1 Austria 1.94% 0.9
of “aid” for Greece
step-up in year 3 + 50 bps service 2 Belgium 2.43% 1.1
charge 3 Cyprus 0.14% 0.1
4 Finland 1.25% 0.6
5 France 14.22% 6.3
 Duration: 3 years 6 Germany 18.94% 8.4
7 Greece 1.96% N/A
 Key Hurdles / Considerations: 8 Ireland 1.11% 0.5
 Several EU national Parliaments 9 Italy 12.50% 5.5
would have to approve 10 Luxembourg 0.17% 0.1
11 Malta 0.06% 0.0
 Greece would have to officially
12 Netherlands 3.99% 1.8
request the assistance
13 Portugal 1.75% 0.8
 Details with IMF would need to be 14 Slovenia 0.33% 0.1
negotiated (multi-week process, 15 Slovakia 0.69% 0.3
expected to end by May 6th)
16 Spain 8.34% 3.7
30

Critical Question: Would markets be sufficiently satisfied with this detail, or would continued
uncertainty around IMF details and nation-state approvals create continued uncertainty?

Source: Deutsche Bank Global Markets Research. ECB. 62

 April 19: Volcanic Ash Cloud Delays IMF Meetings
The delay in The Impact of Iceland’s Eyjafjallajokull Volcano
scheduled IMF /
Greece meetings,  The virtual shutdown of European air travel for 5 days caused the cancellation of in-person
scheduled for April meetings planned for Athens between the EU, the IMF and Greece on April 19th
19th, only  Scaled back meetings took place instead by phone, but slowed down a critical negotiation
exacerbated the
process
uncertainty that
had been driving  Negotiations have since resumed, and are expected to end by May 6th
low liquidity and
high volatility in
Greek securities  Markets reacted very negatively to the continued uncertainty and delays
 Greek bond yields and CDS levels spiked each day as the April 19th week progressed
Planned attendees in
Athens included
senior officials
from the European
Union, the
European Central
Bank and the IMF

63
 April 20: IMF Warning on Sovereign Credit Risk
On April 20th, the IMF
released its
updated Global
Financial Stability
Report …

…and sovereign
credit risks among
advanced
countries were “Risks to global financial stability have eased as the economic
emphasized as a
primary source of recovery has gained steam, but concerns about advanced
renewed risk in the
global financial country sovereign risks could undermine stability gains and
markets
prolong the collapse of credit.”

“The deterioration of fiscal balances and the rapid accumulation of

public debt have altered the global risk profile. Vulnerabilities
now increasingly emanate from concerns over the sustainability
of governments’ balance sheets.”

- IMF Global Financial Stability Report (April 20th, 2010)

64
 April 22: Greece 2009 Fiscal Deficit Increased
Greece’s debt crisis Greece’s 2009 Fiscal Deficit Forecast
reached a dramatic
crescendo on April
 On April 22, 2010, Greece’s 2009 budget deficit was revised higher for the 4th time,
22nd as Eurostat
to 13.6% (or US$44.3 billion), up from a prior estimate of 12.9%
upwardly revised
Greece’s 2009  Eurostat indicated that Greece’s debt is 115% of the size of the economy (EUR
fiscal deficit to 273.4 billion, or US $395 billion)
13.6%, the 4th such
revision in the last
year  Eurostat indicated that uncertainties around Greek economic data could cause a 5th
revision, up to 14.1%
Markets reacted very
dramatically on the Greece’s 2009 Budget Deficit Revisions
news
April 2009 Forecast October 2009 Revision January 2010 Revision April, 22, 2010
0

‐2

‐4

‐6
Percent (%)

‐8

‐10

‐12

‐14

‐16 Greece revised its 2009 budget deficit 4 times, most recently to 13.6%

Source: Deutsche Bank Markets Research. Moody’s. WSJ. 65

 April 22: Moody’s Downgrades Greece to A3
Review of Moody’s Downgrade

On April 22nd,  Downgrade: Greece’s government bond rating downgraded from A2 to A3 and placed on review
Moody’s for further possible downgrade
downgraded
 A3 is just 4 notches above “junk” (non-investment grade) on Moody’s ratings spectrum
Greece from A2 to
A3 and placed
them on review for  Drivers of the Downgrade:
further possible
downgrade  Debt will only stabilize at a more costly level than previously anticipated
 Uncertainty about credible debt stabilization
 Headwinds of higher interest rates and lower economic growth
 EU’s fractious mobilization of emergency aid

“It is unlikely that the rating will remain at A3, unless the government’s
actions can restore confidence in the markets and counteract the prevailing
headwinds of higher interest rates and low growth that could ultimately
undermine the government’s ability to sustainably cut debt levels.”
- Moody’s Investor Service (April 22, 2010)

66
 April 23: Greece Formally Activates EU / IMF Aid
Key Next Steps
Following the
1) ECB and EC will formally assess Greece’s application for aid
sharpest
deterioration in  Should be a formality
Greek bond market
conditions on April
22nd since the 2) European Council must unanimously grant the joint-aid package
crisis began,  Low risk of rejection; can be done via teleconference
Greece’s Prime
Minister George
Papandreou, in a 3) Various EU Governments/ Parliaments must approve
live televised
 Risk of one or more nations failing to gain approval
address, formally
activated the  Would not jeopardise the EU deal; but rather, could reduce its size of EUR 30 billion
“request for aid”
from Europe
4) EU / IMF negotiations must be completed on the conditions of additional IMF aid of ~ EUR
15 billion
 Will take additional 1-2 weeks and scheduled to conclude by May 6th
 IMF focused on reform of Greece labor markets, healthcare and pension systems

5) Formal approval from IMF Board

 Size and timing of co-investment from EU will be critical factors

Source: Mark Wall, Deutsche Bank Chief European Economist

“We believe our European partners will act decisively and provide Greece with a safe
haven to rebuild our ship of state with strong and reliable materials.”
-Greek Prime Minister, George Papandreou, announces the decision

to seek EU loans in a live televised address (April 23, 2010)

67
 April 27: S&P Downgrades Greece to BB+ (Non-IG)
On April 27, Greece Review of Moody’s Downgrade
became the first
EU member to  Downgrade: On April 27th, S&P downgraded Greece’s government bond rating from BBB+ to
have its debt BB+ (“junk”) and assigned a negative outlook
rating cut to
“non-investment
grade”  Drivers of the Downgrade:
 Government policy options are narrowing due to weakening economic growth prospects
S&P also warned
 Medium-term financing risks are growing
that investors
could recover as  Massive political pressures for stronger fiscal adjustments
little as 30% of  Uncertain capacity to implement reform quickly (and questionable resolve)
face value if a
Greek debt
restructuring
were to occur

“Based on our updated assessment, we estimate that the adjustment needed

in Greece's primary fiscal balance relative to that of 2008 in order to stabilize
the government debt burden amounts to at least 13% of GDP - a very high
level compared with that which other sovereigns…At the same time, we
expect official lender support to be highly conditional and revocable, and as
such, we do not believe that it provides a floor under Greece's sovereign
ratings.
- Standard & Poor’s (April 27, 2010)

68
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