Deleveraging: Unwinding the Tape

November 5, 2008

Primary Analysts: Neil McLeish +44 20 7677-7481

neil.mcleish@morganstanley.com
Andrew Sheets +44 20 7677-2905
Phanikiran Naraparaju +44 20 7677-5065
Ahmed Nassar +44 20 7677-0257

Morgan Stanley & Co. International plc

The Primary Analyst(s) identified above certify that the views expressed in this report accurately reflect his/her/their personal views about the subject
securities/instruments/issuers, and no part of his/her/their compensation was, is or will be directly or indirectly related to the specific views or
recommendations contained herein.
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Please see additional important disclosures at the end of this report.
Breaking Down ‘Deleveraging’
Over the last several weeks, a dominant theme in client conversations has been ‘deleveraging’. How big
is the problem? How much further will it go? What, if anything, will break the negative feedback loop?

While ‘deleveraging’ has been an oft-proscribed ailment of markets, the difficulty of quantifying the
problem has made it that much more intimidating as a market force. In this note, we attempt to push
back some on the deleveraging theme. This is not the first stage of deleveraging in this credit cycle, and
is unlikely to be the last. But in our view, not enough credit is being given for progress in the market’s
largest, most leveraged sector: Banks

We see deleveraging as an issue that has, and will, unfold in stages.

1) The first stage was dominated by ‘product’ deleveraging in SIVs, ABS CDOs, CPDOs, etc. These
products contained financial leverage and structural leverage in varying degrees, but a strong theme
was the underperformance of ‘higher-quality’ risks. Main underperformed XOver, super-senior
underperformed equity, credit underperformed stocks

2) The second stage was deleveraging by banks, and our analysis of bank balance sheets indicates
that steady progress has been made in reducing asset exposures. Recent capital injections by
governments have dramatically accelerated this process. We remain very bullish on bank debt, and
we view it as a shrinking asset class in the context of further deleveraging

3) The third stage (which we think we have been in) seems more focused on investor deleveraging, as
volatile markets, leveraged positions and tighter credit have all added significant pressure

4) The last stage, in our view, will be deleveraging by (mostly US and UK) consumers. By its nature,
this will take longer to play out, and we see its effect playing out over the course of several years

Please see additional important disclosures at the end of this report. 2

‘Non-Bank’ Deleveraging Underway for Some Time
The hardest aspect of ‘deleveraging’ is separating those who are being forced to sell from the selling that
occurs because of good old-fashioned concern. SIVs and ABS CDOs were both massive players in
corporate and ABS credit markets, respectively. Note the risk reductions here have been going on, almost
continuously, since autumn 2007. But a major adjustment to financial CP post the Lehman default has,
somewhat violently, brought the CP market back to its 2001 levels

Asset Backed + Financial CP at 2001 Levels CDO Liquidations Since December 2007
$Bn Outstanding Cumulative Liquidations ($mm)
2,200 80,000
Asset-Backed CP
2,000 70,000
Financial CP
1,800 Combined 60,000
1,600 50,000
1,400 40,000
1,200 30,000
1,000 20,000
800 10,000
600 0

Jun-08

Jul-08
Jan-08

May-08

Aug-08
Dec-07

Feb-08

Mar-08

Apr-08

Sep-08

Oct-08
400
2001 2002 2003 2004 2005 2006 2007 2008

Source: Morgan Stanley Research, Federal Reserve

Note: Predominately ABS CDOs
Source: Morgan Stanley Research
Please see additional important disclosures at the end of this report. 3
 Banks Are Making Significant Progress
The capital injections over the last several weeks are substantial, and there is tangible evidence of
deleveraging (raising equity or selling assets both do the trick). Tier 1 ratios for major US and European
banks are now substantially higher than a year ago, despite the deluge of write-downs and provisioning.
Banks are certainly shedding assets too but, importantly, this has been a steady process, in our view, not
a recent phenomenon. Particularly important to our world, over US$121 billion of corporate bonds have
been sold off from the balance sheets of the Primary Dealers over the last year

Tier 1 Ratios Post-Injections & Capital Raises Far Fewer Corporate Bonds on Dealer Balance Sheets
Tier 1 Ratio $Bn Corporate Bonds held by Primary Dealers
14% CS $250

13%
$200
12% RBS
BARC
11%
DB $150
C
10% JPM
BAC BNP
9% SocGen $100

8%
$50
7%

6% $0
3Q07 4Q07 1Q08 2Q08 3Q08 3Q Pro Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul-
Forma 01 02 03 04 05 06 07 08
Source: Morgan Stanley Research Note: Corporates >1yr in maturity
Source: New York Federal Reserve
Please see additional important disclosures at the end of this report. 4
Focusing on Bank Exposure to Leveraged Finance
To focus on bank risk reduction in more detail, we turn to the leveraged finance sector. Net exposures
among large underwriters have fallen 68% YoY, through a combinations of write-downs, sales and
terminations. Again, progress here has been measured and steady over several quarters, which is
important given the size of the exposure that needed to be worked through

Major Reductions in Leveraged Finance Risk Risk Reduction Through Lower Marks
$Bn Outstanding Leveraged Finance Exposures GS Avg. Mark on Leveraged Finance (% of Par)
$350 LEH 100%
MER
JPM 95%
$300 - 68% Citi
BAC RBS
UBS 90% BNP
$250
BARC
DB
RBS 85%
$200 DB
CS BAC
80% Citi
BNP
$150 GS
75% MER
LEH
$100
70% JPM

$50
65%
CS
$0
60%
3Q07 4Q07 1Q08 2Q08 3Q08
4Q07 1Q08 2Q08 3Q08

Source: Morgan Stanley Research, 5

Please see additional important disclosures at the end of this report.
Company Reports
High Quality Responding Differently to ‘Deleveraging’
A major theme of the ‘deleveraging’ from earlier this year was the underperformance of ‘higher-quality’
assets, as investors looked to shed negative convexity, and banks looked to hedge notional risk (which is
easier to do up the capital structure. Super-senior tranches underperformed equity, LVol underperformed
HVol, and AAA ABX and CMBX were hammered. This is not the case today. Credit is only back to March
wides while equities made large new lows. Super-senior tranches have been stellar, and cyclicals (Hvol)
were hit hard. So, something is certainly different about the most recent ‘deleveraging’ wave

Super-Senior Performance Is Telling HVol vs. LVol: Different Deleveraging Response

Cumulative Delta-Neutral Return
HVol
5%
400
4% Super-Senior Outperforming, Today
despite ‘deleveraging’ 350
3%
300
2%
250
1%
200
0%
150
-1%
March 13
-2% 100

-3% 50
Super-Senior suffers,
‘deleveraging’ blamed
-4% 0
Dec-07 Mar-08 Jun-08 Sep-08 0 25 50 75 100 125 150
LVol
CDX 30-100% iTraxx 22-100%
Source: Morgan Stanley Research Source: Morgan Stanley Research, Bloomberg
Please see additional important disclosures at the end of this report. 6
Tighter Credit, Fewer Loans…
Credit rationing ahead of a deteriorating economic backdrop (rather than deleveraging in the strict sense)
better explains the high-quality/low-quality price action in recent moves. A new SLOS from the Fed out on
November 3 indicates that C&I credit conditions continue to contract, and loan growth looks to slow
considerably further

C&I Lending Continues to Tighten in US European Lending Standards Still Net Tighter
Net % of Institutions Reporting Tightening Net % Tightening of Credit Standards To
100 Euro Area Residents
Mortgage 70
C&I
80 Total
Prime Mortages 60
Housing
Subprime Mortgages Non-Fin. Corporates
60 50
Consumer Lending
40
40
30
20
20

0 10

-20 0

-10
-40
Jun- Jun- Jun- Jun- Jun- Jun- Jun- Jun- Jun- Jun- -20
90 92 94 96 98 00 02 04 06 08 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008
Source: Federal Reserve Senior Loan Officers Survey, 3 Nov 08 Source: Morgan Stanley Research, ECB
Please see additional important disclosures at the end of this report. 7
…While Deposit Growth Is Now Outstripping Asset Growth…
Simultaneous to tighter lending standards, banks are pushing aggressively for deposit funding. One can
hardly blame them, given the current gap between unsecured senior yields and term deposits, and equity
markets being increasingly punitive to ‘wholesale funding’. For the first time since 2002, YoY growth in
deposits exceeds YoY growth in assets for US, European and UK banks. Less spending by consumers
and a broader investor move into cash over the last two months also help

Deposit Growth Now Greater than Asset Growth… …and Deposit Funding Looks Very Attractive
YoY Asset Growth - YoY Deposit Growth

10% 9.0%
UK Fixed Rate Bond Deposit rate
8% Yield on £ AA-Rated Bank Paper
8.0%
6%

4% 7.0%

2%
6.0%
0%

-2% 5.0%

-4%
US 4.0%
-6% Europe
UK
-8% 3.0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 1996 1997 1999 2000 2002 2003 2005 2006 2008
Source: Morgan Stanley Research, ECB, BoE, Federal Reserve Source: Morgan Stanley Research, BoE, iBoxx
Please see additional important disclosures at the end of this report. 8
…Meaning That Bank Debt Is a Shrinking Asset Class
Lending continues to tighten, deposits are growing faster than new loans, and government-supported
funding avenues are being made available to banks. With all this, the attractiveness of unsecured funding
via capital markets at current prices is certainly reduced, helping to push net issuance in bank debt
negative for the first time since our data began. Even if we repeat 2004-05 issuance trends, a heavy
redemption profile will mean bond supply continues to contract. This is a technical positive for bank debt

Net Issuance Now Negative, and Barring a Major Capital Markets Reversal, Will Stay That Way
12m Net Issuance / Nominal GDP
30%

25% Financial Net Issuance

Assuming 2004 Issuance Going Foward
20%

15%

10%

5%

0%

-5%
Bond Supply Shrinking

-10%
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Source: Morgan Stanley Research, Dealogic Please see additional important disclosures at the end of this report. 9
Hedge Funds and Deleveraging
Can we quantify pressure to de-lever at hedge funds? Through September 2008, net outflows were fairly
small in relation to overall assets, but we acknowledge the ‘prisoner’s dilemma’ at work here, as many
investors must prepare for outflows that only some will eventually experience

Net Asset Flow from Credit Hedge Funds… …but Credit Hedge Fund Assets Are Still Well
Above 2006 Levels
Net Asset Flow $Bn Credit HF Assets $Bn
35 250

30 FI: Corporate FI: Corporate

FI: Asset Backed 200 FI: Asset Backed
25
Credit Arbitrage Credit Arbitrage
20
Distressed Distressed
150
15

10
100
5

0
50
-5

-10
0
2008 YTD
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008 Q1
2008 Q2
2008 Q3
Source: Hedge Fund Research, Morgan Stanley Research Source: Hedge Fund Research, Morgan Stanley Research
Please see additional important disclosures at the end of this report. 10
The Scope for Further European Loan Sales?
Further deleveraging in European secured loans will be a story of the various holders. CDO
managers (ie, CLOs) will be strong hands, in our view, as only ~5% of these vehicles have MtM
triggers (the rest enjoy term funding of liabilities at attractive terms). CLOs are restricted from
buying large parts of the loan market because prices are too low, as CLO mandates generally
require a minimum price of $80 on purchases of new loan collateral.

In the table below, we attempt to estimate the holder base of leveraged loans from disclosures of
new issue purchases, adjusted for repayment profiles and vintage balance of the current market.
While imperfect, we think it helps to put the size of the various holders in context

Estimates of Holdings of European Leveraged Loans

Non- Prime Rate Rate /
European European Securities Finance CDO Credit High Yield Retail
Vintage Banks Banks Firms Co. Insurance Managers Funds Funds Total
2004 € 1.0 € 5.8 € 0.5 € 0.1 € 0.1 € 2.1 € 0.2 € 0.0 € 9.8
2005 € 4.3 € 21.7 € 1.8 € 1.0 € 0.4 € 13.2 € 4.1 € 0.0 € 46.6
2006 € 8.0 € 35.9 € 4.2 € 1.1 € 0.3 € 36.3 € 8.2 € 0.6 € 94.5
2007 € 12.3 € 46.6 € 11.3 € 2.0 € 1.0 € 56.2 € 22.5 € 5.2 € 157.0
2008 € 5.3 € 29.1 € 1.5 € 0.3 € 0.6 € 8.6 € 5.5 € 0.5 € 51.3
Total € 30.9 € 139.1 € 19.2 € 4.5 € 2.4 € 116.3 € 40.5 € 6.2 € 359.2

Note: Data suggest that nearly all 2003-vintage and earlier loans have been refinanced
Source: Morgan Stanley Research, S&P LCD

Please see additional important disclosures at the end of this report. 11

Navigating the Stages of Deleveraging
‘Deleveraging’ has been a dominate market theme over the last several weeks, but it is hardly a new one.
We have gone through several stages of deleveraging since the crisis started, this is only the most recent

We believe that the deleveraging of the banking system (and large swathes of leveraged vehicles) has
progressed much further than investors give credit for. Based on client conversations, it is here where we
differ most from the consensus. The major banks in Europe and the US have raised significant amounts of
Tier 1 capital, and aggressively marked down large quantities of credit assets. Overall, we believe that
significant bank deleveraging has already occurred

Technicals for bank paper are also positive, in our view. Banks are tightening credit, and appear to be
taking in deposits faster than new loans are being granted. At the same time, large new providers of bank
funding have sprung up in the form of bank-guaranteed paper (where investors are indexed to a
Super/Sovereign benchmark), and central governments themselves. All these help to explain why
unsecured bank debt is now a shrinking asset class, and could remain one over the next 18 months.

Investor deleveraging remains a risk in higher-beta, less liquid parts of the market where it will take time
for new investors to step into the market (e.g., leveraged loans).

The last stage will be deleveraging of the consumer, which is just starting and will drive a severe hit to
cyclical earnings in 2009. Bank paper remains our preferred sector, but we would still be looking to go
long non-cyclicals that have been beaten down by recent investor deleveraging (German Cable Loans,
Telecom, Utilities, IG Pharma) against more cyclical credits. We are aggressive buyers of IG new issues,
believing they select for credits which have market access, are cheap, and allow investors with dry
powder to invest alongside those in a similarly strong position

Please see additional important disclosures at the end of this report. 12

Rating Distribution Table

Credit Products Rating Distribution Table

(as of Oct 31, 2008)
Coverage Universe Investment Banking Clients (IBC)
% of % of % of
Rating Count Total Count Total IBC Rating Category
Overweight 82 36% 49 33% 60%
E qual-weight 89 39% 61 41% 69%
Underweight 56 25% 37 25% 66%
Total 227 147
Coverage includes all companies that we currently rate. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received
inv estment banking compensation in the last 12 months.

Analyst Ratings Definitions

Overweight (O) Over the next 6 months, the fixed income instrument’s total return is expected to exceed the average total return
of the relevant benchmark, as described in this report, on a risk adjusted basis.
Equal-weight (E) Over the next 6 months, the fixed income instrument’s total return is expected to be in line with the average total
return of the relevant benchmark, as described in this report, on a risk adjusted basis.
Underweight (U) Over the next 6 months, the fixed income instrument’s total return is expected to be below the average total
return of the relevant benchmark, as described in this report, on a risk adjusted basis.
More volatile (V) The analyst anticipates that this fixed income instrument is likely to experience significant price or spread
volatility in the short term.

Please see additional important disclosures at the end of this report. 13

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