SP Credit Market Dislocation Sep2008

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The Credit Market Dislocation:Putting The Key Factors InPerspectiveRatings Services:Mark Adelson, Chief Credit Officer, New York (1) 212-438-1075; [email protected]

Table Of Contents

Market Distress By Sector

Ramifications

Silver Linings

Takeaways

Notes

September 3, 2008

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The Credit Market Dislocation:Putting The Key Factors In PerspectiveAs in past periods of market stress, today's market dislocation is accompanied by sizable helpings of confusion and

misunderstanding. Naturally, part of the confusion relates to why market distress is occurring. More interestingly,though, part also relates to the differing degree to which it has affected different sectors of the fixed-income capital

markets.

On the issue of "why," the short answer seems to be that leverage plus speculation fueled by "financial engineering"

and derivatives such as collateralized debt obligations (CDOs) were the primary drivers. Financial engineers started

with essentially manageable risks from the residential mortgage sector, but then concentrated and amplified those

risks. Hindsight reveals that they created securities that were vulnerable to rapid and severe deterioration far beyond

what market participants had anticipated.

The issue of how strongly the market distress has affected different sectors is trickier to assess. Many segments of the

capital markets have felt the impact of stress. However, the severity of that impact has not been uniform. It has beenmost pronounced in two sectors: CDOs of structured finance instruments (SF CDOs) and asset-backed securities

(ABS) backed by second-lien mortgage loans. In both, we believe there are likely to be widespread defaults of

securities that initially carried ratings of 'AAA'.

By contrast, the first-lien subprime mortgage ABS sector has displayed less deterioration. In our view, this sector

likely will suffer widespread defaults of most securities initially rated at the 'BBB' and 'A' levels, but few defaults of

securities initially rated at the 'AAA' level.

The general media has blurred this distinction at times by using the term "subprime securities" to refer

indiscriminately to both SF CDOs and first-lien subprime mortgage ABS. That confusion may have spread

misunderstanding about the true causes and triggers of the current problems in the housing and financial sectors. Ifpolicymakers misunderstand the true causes, they cannot frame effective policy responses. If investors misunderstand

the true causes, they cannot frame effective defensive strategies. Only with a more incisive understanding of what

has happened can both groups craft effective policies and strategies.

Market Distress By Sector

First-lien subprime ABS

Contrary to popular belief, the subprime mortgage sector probably was not the primary cause of the market

dislocation (rather, as noted above, the primary cause was the combination of leverage and speculation). However,

the subprime mortgage sector clearly was a contributing cause, and it was the key sector that triggered the release of

pent-up stresses.

The U.S. housing sector currently is experiencing a more severe contraction than at any time since the Great

Depression. That, combined with lax lending standards from 2005 through 2007, is producing high levels of

defaults and delinquencies on first-lien subprime mortgages. In turn, we believe that those defaults and delinquencies

likely will cause widespread defaults of 2005 through 2007 vintage subprime mortgage ABS tranches initially rated

at the 'BBB' and 'A' levels. That result should not be surprising given the high level of stress buffeting the U.S.

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housing sector. Naturally, securities rated initially at the 'BBB' and 'A' levels embody a lower measure of safety than

those rated at higher rating levels.

Indeed, if securities initially rated at the 'BBB' and 'A' levels did not experience defaults resulting from the greatest

level of stress in more than half a century, that would argue that they should have been rated higher in the first

place. To conclude otherwise begs the question of what level of stress should 'BBB' rated securities withstand: a

100-year, 250-year, or 500-year stress?

By contrast, the current performance of subprime mortgage ABS deals suggests to us that defaults of tranches

initially rated 'AAA' should be infrequent (see note 1).

From 2005 though 2007, total issuance of first-lien subprime mortgage ABS was around $1.1 trillion. Of that

amount, around 3%, 5%, and 10% carried ratings at the 'BBB', 'A', and 'AA' rating levels, respectively. Based on

current projections, 2005 through 2007 vintage first-lien subprime mortgage ABS are likely to suffer aggregate losses

around $200 billion (see note 2). To be sure, those are large numbers, but they represent only a moderate fraction of

the total issuance. As noted above, we expect that tranches that initially carried 'AAA' ratings are likely to suffer few

defaults; most had sufficient credit support to withstand losses in excess of 23% and, starting in third-quarter 2006,

many had sufficient credit support to withstand losses in excess of 28%. Thus, the overall performance of subprime

mortgage ABS is reasonably consistent with the severity of stress that the housing market is experiencing.

Some additional figures help put the size of the "subprime issue" in perspective. At the end of 2005, there were

around 109 million occupied housing units in the U.S. Renters occupied 34 million units, while 75 million units

were owner-occupied. Of the 75 million owner-occupied units, 25 million were owned free and clear. Fifty million

owner-occupied units had mortgage debt. Of those, roughly 44 million had prime mortgages, and around 6 million

had subprime mortgages. Of the 6 million households with subprime mortgages, we estimate that the homeowners

of between 1.5 million and 3 million are likely to default on their loans and either have loan modifications or lose

their homes. Accordingly, by this measure, the "subprime issue" directly affects fewer than 3% of U.S. households.

Why, then, has it become such a headline story? There are two main reasons. First, the subprime situation is

connected to the bursting of the U.S. real estate bubble. The inflation of the bubble, during the early 2000s, was one

of the key factors that led to the expansion of subprime lending. However, the two are not the same thing (see note

3).

On a nationwide basis, home prices advanced rapidly during the early 2000s, but not at a rate too far out of line

with historical norms. Chart 1 displays both the level of U.S. home prices and their rate of change from first-quarter

1975 through first-quarter 2008.



The Credit Market Dislocation: Putting The Key Factors In Perspective


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Chart 1

However, in some areas of the country, home prices rose much more quickly than the national average, and much

faster than prices of other things (such as food, transportation, clothing, and entertainment). Charts 2 through 4show the levels of home prices and their rates of change from first-quarter 1975 through first-quarter 2008 for three

states: California, Florida, and Arizona. In essence, home prices in those states formed the bubble that inflated to its

bursting point in 2006.





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Chart 2





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Chart 3





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Chart 4

Second, key changes in the mortgage business occurred while the housing bubble was inflating. Structured finance

assetsparticularly subprime mortgage ABSbecame the main asset class backing CDOs. Demand from the CDOsector pushed spreads tighter on 'BBB' rated subprime mortgage ABS. By the end of 2005, CDO demand for the

securities was so strong that it drove other investors and bond insurers out of the sector. Now, in hindsight, it

appears that without the moderating influences of traditional investors and the bond insurers, subprime mortgage

originators became increasingly lax in their underwriting practices and started to make riskier loans.

Thus, in the subprime mortgage sector, the severe stresses from the bursting of the housing bubble were aggravated

by the effects of lax underwriting practices starting in 2005.

Still, as noted above, current projections suggest to us that the vast majority of first-lien subprime mortgage

ABSthose initially rated at the 'AAA' levelshould not suffer high levels of defaults. And, finally, for those that

do default, the severity of loss is expected to be quite small.

Second-lien ABS

The performance of second-lien ABS is notably poorer. Many of the tranches initially rated 'AAA' from deals issued

from 2005 through 2007 are at risk of defaulting. Fortunately, the dollar volume of such dealsroughly $150

billionis much smaller than the volume of first-lien subprime mortgage ABS during the period.

Although the housing and residential mortgage sectors are experiencing significant stress, we do not believe that





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today's conditions are sufficiently extreme, by themselves, to explain widespread defaults of securities initially rated

at the 'AAA' level. So, what happened in the second-lien area? In our opinion, second-lien mortgage lending changed

during the mid-2000sand past experience gave a false signal about future performance under stressed conditions.

One key change was an increase in so-called "piggyback seconds," which are purchase-money second-lien loans.

Another key change, related to the first, was significantly higher combined loan-to-value ratios (CLTVs) in

second-lien loans.

A third key change was in consumer behavior. Around the time home prices started to decline (late 2006),

consumers became increasingly willing to default on their second-lien loans. They realized that second-lien lenders

were unlikely to initiate foreclosures. Defaulting consumers concluded that damage to their credit reports was not a

consequence that was bad enough to deter them from defaulting. The old-fashioned notion that defaulting would

bring disgrace, shame, dishonor, and stigma appears to have been supplanted by the idea that the decision to default

is purely an economic one.

Although the first two changes were visible at the loans' origination, the third was not apparent until performance

of the loans could be observed. The combined effect of all three was an unprecedented increase in defaults on

second-lien mortgage loans. The early 2000s' "conventional wisdom" about second-lien mortgage loanswhichvirtually all market participants embraced, including investment banks, issuers, and investorsviewed the product

as quite risky and requiring higher credit support levels than any other residential mortgage product. However, the

historical experience upon which the "conventional wisdom" had rested had no precedent for what subsequently

happened. The combination of more piggyback loans, higher CLTVs, and changing consumer behavior produced

never-before-seen levels of risk in second-lien loans. The result was that virtually everyone in the sector was

blindsided.

Fortunately for the capital markets, the second-lien mortgage ABS sector is much smaller than the first-lien subprime

sector. As noted above, from 2005 through 2007, the total issuance of second-lien mortgage ABS was only around

$150 billion, compared with more than $1 trillion for the first-lien subprime mortgage sector. Thus, although the

intensity of credit problems is very highreaching the senior, 'AAA' level of many dealsthe total impact is not

significantly greater than that within the first-lien subprime sector.

SF CDOs

The SF CDO sector has suffered the worst of all. Starting around 2004, SF CDO issuance volume started to increase

rapidly. Professionals in the sector fueled the expansion by creating SF CDOs backed primarily by subordinate

tranches of subprime mortgage ABS deals and second-lien mortgage ABS deals. In fact, the demand from SF CDOs

for subprime mortgage ABS was so strong that it outpaced the available supply. To satisfy the higher demand,

investment banks started creating "synthetic" ABS using derivatives known as credit default swaps (CDSs).

Ultimately, the volume of synthetic ABS in the SF CDOs exceeded the volume of actual securities by a factor of

roughly 4 to 1.

As shown in chart 5, from 2004 through 2007, cumulative issuance of SF CDOs amounted to more than $600

billion.





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Chart 5

Many of the SF CDOs focused primarily on subprime mortgage ABS rated initially at the 'BBB' level. Those SF

CDOs were dubbed "mezzanine" deals. Others focused primarily on securities rated at the 'A' and, to a lesser

degree, 'AA' levels. Those were called "high-grade" SF CDOs. Current projections suggest that the vast majority of

mezzanine SF CDOs will suffer defaults into their tranches that initially carried ratings at the 'AAA' level. Although

the matter is somewhat less clear, we believe that a high proportion of high-grade SF CDOs is likely to suffer the

same fate. We expect that the dollar volume of defaulting securities initially rated at the 'AAA' level, as well as the

magnitude of losses on those securities, is likely to exceed the volumes of defaults and losses on 'AAA' securities

from the first-lien subprime mortgage and second-lien mortgage ABS sectors.

When the dust finally settles from the current market dislocation, we believe that losses on SF CDOs likely will

amount to between $200 billion and $300 billion, including a notable proportion of securities initially rated at the

'AAA' level. Those will represent the major share of losses booked by financial institutions and other market

participants.

By comparison, we believe that losses on second-lien mortgage ABS (including those backing SF CDOs) likely will

amount to roughly $50 billion, also including a high proportion of securities initially rated at the 'AAA' level. As

noted above, losses on first-lien mortgage ABS (including those backing SF CDOs) likely will amount to around

$200 billion, very little of which will have an impact on securities initially rated at the 'AAA' level. A large share of

those losses will not be felt directly by investors, but only indirectly because the securities were repackaged into SF

CDOs.





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Ramifications

Although many securities have already suffered severe deterioration of credit quality, most of them have not yet

suffered payment defaults. Nonetheless, a number of institutions have booked staggering writedowns attributable to

SF CDOs (see note 4). For example, from third-quarter 2007 through second-quarter 2008, Citigroup announced

total writedowns of roughly $25 billion attributable to SF CDOs (see note 5).

Likewise, Merrill Lynch reported net writedowns attributable to SF CDOs of $23.2 billion for 2007. Later, Merrill

Lynch reported SF CDO-related writedowns of more than $3.0 billion for first-quarter 2008 and of around $5.0

billion for second-quarter 2008 (see note 6). At the end of July, Merrill Lynch sold roughly $30 billion (face

amount) of its remaining SF CDO positions at a price of just 22 cents on the dollar, and, in doing so, financed 75%

of the purchase price, receiving only around 5 cents on the dollar in cash.

UBS, a major Swiss financial institution, had a similar experience. It booked SF CDO-related writedowns of $12.8

billion for 2007 (see note 7). Then it booked further SF CDO-related writedowns of $1.5 billion in first-quarter

2008 and $2.2 billion in second-quarter 2008.

Apart from their impact on banks and securities firms, SF CDOs have been a major factor in the deterioration of the

bond insurance sector. Most of the major players in that sector have suffered downgrades in the past year. Only a

few have managed to retain 'AAA' ratings.

The overall result has been a significant dislocation of financial markets, including a contraction of liquidity for all

types of complex and esoteric assets. Liquidity has contracted for simpler instruments as well, though to a somewhat

lesser degree. Bid-ask spreads for everything except instruments of the highest perceived quality have become very

wide. This, in turn, has caused a noticeable tightening of credit in both the consumer and commercial spheres.

Silver LiningsOn the other hand, the news is not all bad. First, many SF CDOs included CDSs on subprime mortgage ABS rather

than the actual securities. Because a CDS is a two-party contract, every dollar lost by one party is a gain for the

other (see note 8). Thus, for every dollar of SF CDO-related losses attributable to CDS, there ought to be an

offsetting dollar of gain elsewhere in the global financial system. Unfortunately, losses, but not the offsetting gains,

seem to have been concentrated in many institutions that are key players in maintaining the smooth operation of the

global financial system.

Second, the 2008 market dislocation has revealed some of the systemic risks posed by high leverage and speculation

fueled by financial engineering and derivatives. Indeed, some commentators have recently argued that the

over-the-counter (OTC) market model for fixed-income derivatives and other complex instruments is largely toblame for the current problems (see note 9). Identifying problems is the first step to solving them. Recognition of the

role that complex derivatives and financial engineering have played may give rise to wise policy responses that

protect the capital markets from similar disruptions in the future.

Finally, from the narrow standpoint of the U.S., sales of SF CDOs to investors outside the U.S. may have exported

some of the losses related to the bursting of the U.S. housing bubble. This has the potential effect of softening the

blow to the U.S. economy and the U.S. financial system.





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Takeaways

The subprime problem, the housing bubble, and the market dislocation are related, but they are distinct events.

Understanding their interrelationship is essential for identifying the weak points of the financial system and for

framing defensive strategies (for investors) and corrective policies (for policymakers).

The financial markets have the opportunity to learn from recent experience and to become stronger. It now remains

to be seen whether investors and policymakers will heed the lessons and seize the opportunities. At a minimum, all

types of market participants should now be on notice that leverage and speculation born of financial engineering

and complex derivative activities can produce unanticipated results.

Summary Of Selected Data And Projections

Product Security issuance Projected losses Comments

First-lien subprimemortgage ABS

Roughly $1.1 trillion from2005 though 2007

Roughly $200 billion Losses concentrated primarily in mezzanine and subordinate tranches thatcarried initial ratings below 'AAA'. A high proportion of tranches withlosses were repackaged into SF CDOs.

Second-lien mortgageABS

Roughly $150 billion from2005 through 2007

Roughly $50 billion Losses likely to affect all layers of the deals' capital structures, includingmany senior tranches that carried initial ratings of 'AAA'.

SF CDOs Roughly $600 billion from2004 through 2007

$200 billion to $300billion

Losses likely to affect all layers of the deals' capital structures, includingmany senior tranches that carried initial ratings of 'AAA'.

Notes

(1) The fate of the tranches initially rated at the 'AA' level is the most uncertain. Those are the tranches on the

"cusp" of current projections. In our view, there is a reasonable chance that a significant proportion of those

tranches could default. It is debatable whether the stress in the housing and residential mortgage sectors is severe

enough, by itself, to explain defaults of such securities.

(2) Losses on the underlying subprime mortgage loans likely will be somewhat higher. A portion of the losses on the

loans are absorbed by "excess spread" within each deal. The result is that ultimate losses on the securities are lower

than the losses on the related loans.

(3) The housing bubble itself merits headline attention because it affects all of the 75 million households that own

their own homes. Beyond the mortgage sphere, declining home prices can have important effects because they reduce

both household wealth and consumer spending.

(4) To date, most of the writedowns reflect market value losses rather than actual credit losses. In the short run,

market value losses can exceed projected credit losses because of supply-demand imbalance in the secondary market.

(5) Citigroup earnings announcements report the quarterly SF CDO writedowns as follows: third-quarter 2007:$1.8 billion; fourth-quarter 2007: $14.3 billion; first-quarter 2008: $5.7 billion; and second-quarter 2008: $3.2

billion.

(6) For first-quarter 2008, Merrill Lynch had net writedowns of $1.5 billion on SF CDOs and $3.0 billion of credit

valuation adjustments related to hedges with financial guarantors, most of which relate to U.S. super-senior SF

CDOs. For second-quarter 2008, Merrill Lynch had net writedowns of $3.5 billion on SF CDOs and around $1.5





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billion of credit valuation adjustments related to hedges with financial guarantors, most of which relate to U.S.

super-senior SF CDOs.

(7) According to a special report to shareholders, dated April 18, 2008, about two-thirds of total UBS losses in 2007

were attributable to the bank's CDO desk. About half of the bank's total losses for the year came from super-senior

CDO positions.

(8) The equivalence of gains and losses under a CDS breaks down if the party obligated to pay defaults on its

obligation. Collateral-posting requirements mitigate that risk in many CDSs, but they do not fully eliminate it.

(9) Whalen, C., "Yield to Commission: Is an OTC Market Model to Blame for Growing Systemic Risk?" J. of

Structured Fin., vol. 14, no. 2 (Summer 2008).





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SP Credit Market Dislocation Sep2008