European Credit Spreads Drive: Understanding and Impacts

1. 13 January 2009 European Structured Finance 2008-09 Alexander Batchvarov, CFA +44 20 7995 8649alexander_batchvarov@ml.com Ludwig Clement +44 20 7995 0432ludwig_clement@ml.com Caspar Cook, CFA +44 131 473 1055caspar_cook@ml.comAltynay Davletova, CFA +44 20 7995 3968altynay_davletova@ml.com James Martin +44 20 7995 0110james_martin@ml.com Furquan Kidwai +44 20 7996 2536furquan_kidwai@ml.com Sabine Winkler +44 20 7995 4756sabine_winkler@ml.com What Drives European Credit Spreads - 2009 Product ID

2. 2008-09: In search of a strong footing

3. 2008 - an exceptional year in every respect • Rated new issuance exceded Eur700bn, much higher than in previous years • Public placement - maybe less than 2.5% of new issuance • Main primary market investor- the central banks • Secondary market - main focus of remaining investors • Spreads - wide across stack, asset classes and geographies • CDS on ABS - a viable investment instrument for the cash strapped investor; volatile basis • Spread volatility - not a surprise, but how much is driven by fundamentals and how much by technicals • US and European ABS - mutually re-enhanced relationship in secondary spreads

4. 2008 - an exceptional year in every respect • Performance of European structured finance bonds deteriorating, but the majority of the European structured finance transactions perform according to initial expectations • Rating agencies changes in methodology and/or assumptions adding to market instability - an event risk rather than credit risk • Deteriorating credit performance - is the actual deterioration within expectations or beyond expectations? • MtM sensitivity - unnecessary for structured, illiquid and difficult to value positions - drove traditional investors away from the market and converted buyers into forced sellers • Reputational issues - media frenzy and financial institutions reputation - better lose one’s shirt in equity than a shirt’s button in structured finance! • Wider markets’ lack of understanding of the structured finance world • Events that were never meant to happen - demise of the monolines, hitting a MT NAT test (who gave that advise?!), collapse of the commercial paper market, rise and fall of the systemic bank risk, decline of covered bonds liquidity and collapse of related market-making mechanism, multi-notch downgrades due to radical changes in rating methodology - a squadron of blcak swans!

5. The demise of the parallel banking system • Banks and finance companies actively originate loans in the expectation that they can off-load them to long-term investors • Securitisation is the transformation mechanism by which pools of loans are converted into bonds with different risk profile • Securitisation bonds are sold to investors with different risk appetite - investors of the senior part of 70-90% of each transaction play a key part in the placement • Investors base for the senior and bulkiest part of the securtisation bonds comprise banks, SIVs, ABCP conduits and hedge funds - all rely on short-term funding and/or leverage • The parallel banking system replicated the traditional gap (short-term funding / long-term investing) of traditional banking system without the benefit of CB aid • A run on the parallel banking system occurred when the short-term markets shut down, bringing the main players of the parallel banking system to their knees • The parallel banking system provided credit to the tune of USD1.5-1.8trl p.a. globally in the preceding five years (Western Europe E350-500bn p.a. from securitisation plus E150-200bn p.a. from covered bonds) • The elimination of credit flows from the parallel banking system without a replacement provider of that credit in the near team is having a devastating effect on the markets and the economies of many countries around the world

6. Government actions • Actions associated with providing liquidity to the markets • Repo facilities and repo eligibility (categories II, III, IV, V) • Actions meant to stimulate new lending • Guarantee for financing of new lending (the UK) • Actions to support borrowers facing debt service difficulties • Spain and Italy, so far • Actions to prop up the banks and stimulate new debt issuance • Government guarantees for bank debt (many countries for 3 or 5 years), covered bonds (Sweden, Ireland, UK), RMBS (UK) • Creating a multiple-tier bond market: government guaranteed (GG) bank debt, GG covered bonds, GG MBS, regular (non-GG) bank debt, legacy covered bonds, legacy ABS and MBS • Loan modifications - self-interest or moral suasion • Additional actions required - social housing, first time buyers, new investors

7. From one to two markets for structured finance • Government related markets for structured finance bonds • Repo facilities - new issuance price to repo, not priced to market • Potential implementation of government guarantees to RMBS and covered bonds (UK) • Government-guaranteed covered bonds vs. covered bonds from government supported banks • Legacy markets for structured finance products • Secondary markets for ABS and MBS • Secondary markets for covered bonds • Wide spreads for liquidity or credit reasons, or both • Interaction among the different primary markets in the presence of government guarantee • GG bank debt - most attractive pricing but limited maturity (3 or 5 yrs) and size per government support packages (on balance sheet debt) • Covered bonds - attractive pricing for the guaranteed covered bonds but admin cost not justifiable, hence covered bonds attractive for maturities beyond 3/5 years (on balance sheet debt with encumbrance, investor acceptance in light of product disparity) • Securitisation - attractive due to clear asset/liability matching and maturity/ cash flow profile(regulatory issues about retention and capital treatment, structures and asset investor acceptance) • Short-term and long-term distortions and their cure

8. In Search of New Investors and New Asset Allocation • Remaining traditional investors • Banks - the MtM issue, overload, reinvesting amortisation, tight liquidity, delevering • Insurance companies - 2012 and capital requirement rules • Pension funds - different degree of past involvement • Government guaranteed paper - the SSA investor • Distressed investors • Fixed income funds, alternative credit funds • Timing the entry, sizing the return • ‘Price Distressed’ bonds vs ‘Credit Distressed’ bonds • Challenges in sizing the distressed debt market in Europe • Cross-over investors • Natural fit - private equity investors and CLOs; property investors and CMBS • Tenuous fit - bank equity investors and RMBS/ ABS • Developments and returns on the traditional market of a given investor in comparison with availability and return of structured finance instruments - dividend yield&capital return vs. coupon&principal return

9. The Asset Allocation Questions • Preferred part of the distressed universe - price vs credit distressed • Fit into the existing allocation guidelines or need to modify guidelines • Availability of the necessary skill set in the organisation • Allocation to fixed income / alternatives / distressed in traditional equity portfolios • Realistic assumptions about equity returns • Ability to use derivatives to hedge or take exposure • Ability to hold investments to maturity

10. The future of Structured Finance Pros • The need for credit and the inability of banks to provide it from wholesale and deposits • Demographics demand fixed income instruments • Investors preference for secured investment instruments • Availability of skilled structured finance professionals displaced by the upheaval in investment banking • Securitisation as a truly match-funded funding mechanism • Attractive relative value of securitisation and covered bonds post dislocation Cons • Regulatory zeal/ hyperactivity - BIS2.2 and the X% rule • Insufficient investor base • Ambiguity of rating agencies role • Negative publicity surrounding structured finance • Crowding out effect of government guaranteed debt and ‘nationalisation’ of the banks

11. Expectations for 2009 • De-leveraging and re-capitalisation of banks • Stabilisation or at least sizing the trough of the residential and commercial real estate markets • Sizing the depth of the economic turn in Europe • Reduction of systemic risk in the banking system • Clarity as to the range of measures the governments are prepared to take to support the economies, consumer and corporate sectors, market liquidity and funding availability • Accepting a scenario-based risk-reward approach to investing • Differentiating between price distressed and credit distressed bonds, new and legacy bonds

12. Islamic finance

13. Sukuk market in picture Global Sukuk issuance (US$bn) GCC Sukuk issuance (US$bn) Source: Zawya, Merrill Lynch, IFIS Source: Zawya, Merrill Lynch, IFIS 5yr FLT, Corporate Sukuk spreads (bps) Source: Zawya, Merrill Lynch, IFIS What Drives European Credit Spreads - 2009

14. Sukuk market in picture (contd.) Sukuk issuance by country (US$bn) 2007 vs 2008 Sukuk issuance (US$bn) Source: Zawya, Merrill Lynch, IFIS

15. Sukuk spreads widened and issuance declined • Sukuk spreads widened 2-3 times; • Corporate sukuk priced in the range of 115 – 275bps; Saudi spread declined on GSE issuance • Widening attributed to shariah ruling on asset buy-back in sukuks, contagion from the global economic slow down and uncertainty regarding the peg issue • Issuance declined 58% y-o-y; only Bahraini market kept up with last year’s numbers – local money market instruments in demand • Malaysian local currency sukuk dominated the market with US$5.3bn issuance • Indonesia a new market entrant: US$677mn vs US$44mn (in 2007); fixed rate • Issuance predominantly in local currency • Shariah-compliant syndicated lending continues as an alternate debt supplier

16. The sukuk controversy • Purchase price guarantee in Musharaka, Mudaraba and Wakala structure declared non-compliant shariah; effectively eliminating principle guarantee • Equity/ownership or securitisation structures preferred • Ijara (sale and lease-back) structure exempted from this restriction • Musharaka and Mudaraba sukuks down to 17% and 5% respectively from 43% to 21% last year; Ijara sukuks up to 54% from 30% in 2007 YoY structural shift in sukuk issuance

17. Islamic Securitisation • First land securitization in Abu Dhabi and the UAE: Sun Finance Limited • First 100% local currency ABS; true sale with title transfer for asset isolation • Rated Aa3/A3/Baa3 and pricing in at 200/250/350bps over EIBOR • Some of the transaction features include: • Low WA LTV (49%), 42% over-collateralisation, short WA life (21 months) & pre-funded reserve accounts • Strong state participation in Abu Dhabi’s development, registered land ownership & high-rated backup servicer, positive real estate outlook in Abu Dhabi for short-medium term Source: Moody’s

18. GCC Securitisation: any chance? • Fundamentals:weakening economy and real estate markets; Saudi relatively better • Credit growth: credit growing rapidly, banks’ loan to deposit growth (100% in Qatar, 65% KSA), over-exposure to the real estate sector – need to offload in the capital market • Collateral performance:low non-performing loan ratio supported by strong economic growth; consumer loans exposed to local stock markets (esp. KSA) and real estate; deterioration of assets likely especially the UAE • Demand:local investors and banks; shariah-compliant securitisation to attract Islamic banks; however real estate exposure to be taken with a pinch of salt • Legal issues: untested and evolving legal system; two-tier SPV used so far; free-zones more reliable, replicate English law • Expectations:GCC securitisation to continue; UAE the most developed markets in the GCC; Qatar and Saudi picking up; post-downturn origination to slow down

19. Consumer & mortgage lending • Total loans (% of GDP):UAE (103%), Qatar (69%), Bahrain (64%), KSA (42%), Egypt (48%) Consumer • Deposits (% of GDP):UAE (103%) and Bahrain (96%) leading, position boosted by offshore financial centres • Retails loans:Highest retail loans in Qatar and Bahrain, UAE lagging (6% of GDP) • Private consumption rising; credit card market growing – UAE accounts for 50% Mortgage • Mortgage penetration low across the board; UAE (8%) and Kuwait (10%) top the list • Increasing housing costs to support mortgage growth • Legal infrastructure needs clarity

20. Covered bonds 2008-09

21. Market in numbers • Jumbo market at the end of 2008 compared with the end of 2007 • Annual gross supply: €90bn versus €152bn • Share of special-law-based covered bonds 17% versus 37% • Share of mortgage covered bonds 64% versus 66% • Total volume outstanding: €823bn versus €821bn • Share of special-law-based covered bonds 20% versus 23% • Share of mortgage covered bonds 60% versus 56% • Number of Jumbos issued: 66 versus 99 • Number of Jumbo issuers: 97 versus 80 • Number of products issued in Jumbo format: 24 versus 21 • New special covered bond laws: 2 versus 4 • Jumbo redemptions: €87bn versus €80bn • Initial maturities of new Jumbos: • up to 5 years 89% versus 50% • 6 to 10 years 11% versus 35% • over 10 years 0% versus 18%

22. Market in numbers

23. Market in numbers

24. Challenges • What place do covered bonds have in a bank’s overall funding mix? • Banks adjust their balance sheets and refinancing strategies • Originate-to-retain and originate-to-repo process is in vogue • Secured funding implies structural subordination • Term funding has to gain importance over time • How will the investor base develop and grow? • The development of a domestic investor base becomes crucial • The risk assessment of covered bonds has become more complex • How will the pricing of covered bonds develop? • From a ‘rates plus’ product to a ‘credit minus’ product to an in-between product • Exceptional competition from government-guaranteed bank debt

25. Challenges • Will the spread differentiation by country and issuer stay? • Covered bonds have suffered from a sharp liquidity decline and widening spreads • Spread differentiation between countries and issuers has reached all-time wides • Spread differentiation and risk aversion go hand-in-hand • Flight-to-safety and flight-to-liquidity flows to put upward pressure on spreads • Potential issuer downgrades negatively affect the Jumbo spread performance • Subdued gross supply and €100bn in redemptions should support Jumbo spreads • Spread differentiation by country and issuer to stay • Gradual spread contraction in the longer term

26. Challenges

27. Comeback • The 2009 comeback of covered bonds • Exceptional market conditions have stemmed the flow of new Jumbo issuance • Financing markets have to stabilise and investor risk aversion needs to ease • Banks need a variety of funding instruments and matched refinancing • Banks have to wean themselves off current exceptional government support • The covered bond market dynamics are not fully divorced from the credit market • The reception of a covered bond depends on an issuer’s reputation with investors • An overhaul of the market-making system to restore investor confidence • Combined efforts from the different covered bond market stakeholders

28. UK RMBS

29. UK house prices continue south UK house prices implied by property derivatives UK House price index, YOY change Source: Merrill Lynch Source: Halifax, Nationwide, Land Registry, Merrill Lynch

30. House sales and mortgage approvals drop Volume of UK house sales UK Mortgage approvals (000s) Source: Land Registry Source: Datastream

31. Net lending at depressed levels UK Gross mortgage lending by purpose of loan, £mn UK Net and gross mortgage lending (£mn) Source: CML Source: Datastream

32. UK economy entering recession

33. UK RMBS volumes at record high, on paper UK RMBS issuance by sector, EURbn Source: Merrill Lynch

34. UK RMBS secondary market gets more distressed UK Prime and BTL RMBS indicative secondary spreads UK NCF RMBS indicative secondary spreads UK AAA Prime RMBS basis Source: Merrill Lynch

35. UK prime RMBS performance

36. UK Prime RMBS 90+ arrears 90+ arrears before and in 2008, against pool seasoning Source: ABSXchange, Merrill Lynch

37. UK prime RMBS outlook negative • Macro outlook suggests more pain ahead • Unemployment to reach 8% by 2010 • Losses may reach 2% • Downside risk, but UK government initiatives may be a significant supporting factor • Divergence in performance across master trusts likely to remain • Extension risk rising • Weaker housing market= lower CPR • Step-up calls: not that punitive anymore • Reputational considerations getting weaker

38. UK buy-to-let market YOY change in number of new tenancies (not renewals) signed up in the last 3 months BTL gross and net lending % BTL investor respondents expecting to buy more properties in the next 12 months Is there more properties or tenants (% respondents)? Source: CML, ARLA Surveys

39. UK BTL rental yields Average rental return on houses, by region Average rental return on flats, by region Source: ARLA Surveys Source: ARLA Surveys

40. UK BTL arrears rising BTL sector performance UK BTL 90+ arrears by deal, Oct-08 vs Dec-07 Source: CML Source: ABSXchange, Merrill Lynch

41. while CPRs slowing UK BTL CPR, Oct-08 vs Dec-07 Aire Valley 90+ arrears, before 2008 versus 1-3Q08 Source: ABSXchange, Merrill Lynch Source: Merrill Lynch

42. UK BTL risk exposure vary across deals UK BTL current indexed* LTV UK BTL share of fixed-rate mortgages and below 120% ICR Source: ABSXchange, Merrill Lynch *As reported in investor reports, using Halifax index Source: ABSXchange, Merrill Lynch

43. UK non-conforming RMBS arrears UK NCF 90+ arrears UK NCF 180+ arrears Source: Merrill Lynch, ABSXchange Source: Merrill Lynch, ABSXchange

44. UK NCF RMBS repossessions UK NCF REO, % current balance UK NCF quarterly repossession rate, % current balance Source: Merrill Lynch, ABSXchange Source: Merrill Lynch, ABSXchange, investor reports

45. UK NCF RMBS losses UK NCF cumulative losses, % original balance UK NCF deals with 2009 resets*, % original balance Source: Merrill Lynch, ABSXchange Source: Merrill Lynch, ABSXchange, investor reports *Excludes deals where the amount of resets is less than 10% of original balance

46. UK non-conforming RMBS series UK NCF 90+ arrears and repossessions versus risk factors, by vintage and series*

47. UK NCF RMBS CPRs UK NCF CPR Gap between 3M Libor and BBR (%) Source: Merrill Lynch, ABSXchange Source: Bloomberg

48. UK NCF RMBS: Sizing losses under a stress scenario

49. European RMBS

50. European GDP and unemployment Quarterly GDP growth 2000-Q3 08 (YoY%) Quarterly unemployment rates 2000-Q3 08 (%) Source: Datastream Source: Datastream