Eye on the Market

Eye on the Market May 10. 2011 j.pmorgan Snakes and Ladders. A year ago, Europe announced a framework for providing bridge loans to tide countries over until reform, austerity and renewed growth would allow them to come back to the capital markets in 2012. In the case of Greece, Ireland and Portugal, this does not appear to be working. If anything, as shown on page 2, austerity without an exchange rate adjustment is strangling Greece. As a result, we now enter a complex end-game best explained using a modified version of the ancient Indian board game "Snakes and Ladders", applied to Greece. The game is complex, since the IMF appears focused on saving Greece, while European policymakers appear mostly focused on saving European banks (see charts on page 3). Rumors this morning about another IMF-led package of an additional 30-60 billion Euros for Greece (perhaps collateralized by utility privatization proceeds) may push the problem out a year or so, but the game theory remains the same, since Greece is nowhere Snakes and Ladders (cDlodKla Ka; ZKaAcc) all figures in Euros IL Return To 0' '' Private Debt Markets in 2012-2013 With departure of Dominique Strauss-Kahn from the IMF. the agency's resolve to implement the current troubled program may erode II 17 What about Spain, or Belgium? What if 35 bn is not enough to save Ireland's banks given 290 bn of European/UK bank exposure to Ireland? 16 k Greater schisms between IMF and EU country representatives, given their differing objectives (saving Euro banks vs savipg Greece) 9 At 130 bn of exposure (on 190 bn of collateral) through purchases and bans to Greek banks, ECB can no longer abide its monetary policy role abducted into fiscal support, refuses to lend more 8 Begin your journey back to solvency and debt sustainability 1 'Voluntary' exchange defers the problem to another day, avoids bank writedowns with the approval of EU regulators, but with no relief to Greece's 23 debt/GDP ratio Greek bank deposits: 200 bn and shrbking. Ratings downgrade and speculation on Euro exit accelerates outflows, increasing ECB exposure to Greece 15 Not all European governments or citizens share what some German Social Democrats describe as 'support for EU partners without limit and 10 without hesitation" ECB Rate Hies? Day of rest At 255 bn of borrowing capacity, the EFSF is currently only big enough to fund bailouts for Portugal, Greece and Ireland 22 Unexpected series of events leads to restructuring of Greek ebt; 50°/0•60% haircut may be needed to restore debt sustababity 14 Day of strikes: Move bad( 5 spaces 19 Austerity continues to eat away at Greece's tax base, as the EU/IMF program ignores the precedent of countries in similar conditions benefitting from 30%-40% currency devaluations 6 Cut gov't spending, raise tax collections, enact structural reforms. Then, grow at the same time, reducbg the debt 2 burden relative to GDP 3 Most Greek bonds subject to Greek law do not contain 'Collective Action Clauses' 21 Some private sector investors hold out, do not participate in a voluntary exchange, and benefit from being lree riders", raising political tensions 20 Europe, through the EFSF and other support mechanisms, decides to accumulate Greek debt bdefinitely, bailing out the private sector of all its Greek sovereign holdins 13 European banks hold 50 bn in Greek sovereign debt (mostly held at par), plus 50.80 bn to Greek banks and corporates; largest 4 Greek banks under severe pressure given large Greek debt holdings 12 Tess than 1% decline in Euro bankTier 1 capital ratios, but (a) contagion for Portugal and Ireland. (b) unknown offbalance sheet/derivative exposures to Greece, and (c ) Greek bank run risk rises EFTA01164570 Eye on the Market I May 10, 2011 J.P. Morgan near a trajectory of economic sustainability. Biggest risks which could accelerate the end-game: political cohesion breaking down. or a run on Greek banks. When the European debt crisis first broke. I was informed by some European colleagues that "Greece is not Argentina-. They were right, although not in the way intended: when comparing budget deficits, current account deficits and debt ratios to Argentina 2001, Greece 2009 was twice as bad 'note: Argentina received 70% debt forgiveness'. While it rarely makes sense to accelerate recognition of losses during a financial crisis, the austerity quid pro quos for sustaining the illusion of solvency may be deepening social. economic and political problems in the periphery. Despite their cheapness relative to the US, we remain underweight European equities: we generally do not own peripheral European sovereign debt in our core bonds funds, despite their currently depressed prices; and are focused for now on acquiring distressed portfolios of corporate, commercial and residential real estate loans from over-leveraged European banks. Status Report on Greek austerity program Greece unemployment rate Percent 16% 15% 14% c 250% 13% 12% eD 200% 11% 10% 9% 8% 7% • 6% 2005 2006 2007 2008 2009 2010 2011 Source: National Statistcal Service of Greece. • Euro US Financials Financials U.S. • • • Italy Portugal • • Canada 150% e 100% - 50% 0% 0% SS US Munis • • O. • EM Local ' Greece 2010 • Ireland Spain U.K. France Germany • Greece 2014E 5% 0% 15% 20% 25% Interest Expense to Revenue Source: El. Morgan Securities LLC. OECD. Eurostat. IMF. Japan's debt burden too high to be shown. Greece bank deposits Greece car sales Euros, Billions Thousands, sa 245 30 240 25 235 230 20 225 15 220 10 215 210 205 Jan-09 May-09 Sep-09 May-10 Source: Bank of Greece. Survey of Greece consumers: purchases of major items over next 12 months, Percent balance, sa 10 0 -10 -20 -30 -40 -50 -60 -70 -80 Jan-90 Jan-93 Jan-96 Jan-99 Source: EuropeanCommission. Jan-10 Sep-10 Jan-11 Debt burden by issuer category 400% 350% - 300% 0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Source: National Statistical Service of Greece... Morgan Securities LLC. Greece Industrial Production Index, 2005=100, sa 110 105 100 95 90 85 80 75 Jan-02 Jan-05 Jan-08 Jan-11 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Source: Nation] Stab stoat Service of Greece, M. Morgan Securities LLC. 2 EFTA01164571 Eye on the Market I May 10, 2011 J.P.Morgan Two charts on European bank capitalization and exposure to Greece European bank capital and reserves to total assets Percent 10 9• 8• 7• 6• 5• 4 3 2 1 111111 I I 0 . . , • . IV% ee, be3/419/97 PP.* S44 b +6% 4 70 atese 1/4 70:0/43 /4 ' ea (1 /4? oe epee a ,9,9/ ; Source: European Central Bank. 1 1 Bank claims on Greece Immediate borrower basis - Billions, USD $90 $80 $70 $80 $50 $40 $30 $20 $10 $0 1998 2000 2002 Source: Bank for International Settlements. Excludes derivatives contracts, guarantees extended and credit commitments which amount to an additional 557.9bn for France and Germany as of O32010 French banks 2004 2006 2008 2010 German banks NVill the ECB really raise interest rates when economic conditions are more divergent than they have been in decades? Euro short rate Measure of European economic dispersion Percent Standard deviation of regional utilization and output gaps 6% 4.0% 3.0% 3.5% Capacity utIlizatIon(LHS) 5% 2.5% Priced in 3.0% 4% lightening 2.5% 2.0% 3% ...000•0 1 2.0% 1.5% 2% 1.0% 1.0% 1% 0.5% 0.5% 0% 0.0% 0.0% 2001 2003 2005 2007 2009 2011 2013 1974 1978 1999 Source: Bloomberg. Michael Cembalest Chief Investment Officer 1982 1986 1990 1994 1998 2002 2006 2010 So urce:M. Morgan Private Bank. European Commission. ECB = European Central Bank; EFSF = European Financial Stability Facility: IMF = International Monetary Fund; SA = Seasonally Adjusted The material contained herein is intended as a general market commenta Opinions expressed herein are those of Michael Cembalest and may differ from those of others Morgan employees and affiliates. This information in no way constitutes.. Morgan research and should not be treated as such. 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