EFTA01164570.pdf

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 '0 'Voluntary' exchange defers Return To the problem to another day, '' Private Debt avoids bank writedowns with At 255 bn of borrowing capacity, the EFSF is currently only big enough to fund Most Greek bonds subject to Greek law do not contain 'Collective Action Clauses' Markets in the approval of EU regulators, bailouts for Portugal, Greece 2012-2013 but with no relief to Greece's and Ireland 23 debt/GDP ratio 22 21 With departure of Dominique Unexpected series of events Some private sector investors Strauss-Kahn from the IMF. the leads to restructuring of Greek hold out, do not participate in a agency's resolve to implement ebt; 50°/0•60% haircut may be voluntary exchange, and the current troubled program needed to restore debt benefit from being lree riders", may erode sustababity raising political tensions II 17 19 20 Greek bank deposits: 200 bn Europe, through the EFSF and What about Spain, or Belgium? and shrbking. Ratings other support mechanisms, What if 35 bn is not enough to downgrade and speculation on decides to accumulate Greek save Ireland's banks given 290 Euro exit accelerates outflows, debt bdefinitely, bailing out the bn of European/UK bank increasing ECB exposure to private sector of all its Greek exposure to Ireland? 16 Greece 15 14 sovereign holdins 13 European banks hold 50 bn in Not all European governments Greater schisms between Greek sovereign debt (mostly or citizens share what some k IMF and EU country representatives, given their differing objectives (saving German Social Democrats describe as 'support for EU partners without limit and Day of strikes: Move bad( 5 spaces held at par), plus 50.80 bn to Greek banks and corporates; largest 4 Greek banks under Euro banks vs savipg Greece) severe pressure given large 10 without hesitation" 9 Greek debt holdings 12 At 130 bn of exposure (on 190 Austerity continues to eat away Tess than 1% decline in Euro bn of collateral) through at Greece's tax base, as the bankTier 1 capital ratios, but purchases and bans to Greek ECB EU/IMF program ignores the (a) contagion for Portugal and banks, ECB can no longer Rate precedent of countries in Ireland. (b) unknown offbalance abide its monetary policy role Hies? similar conditions benefitting sheet/derivative exposures to abducted into fiscal support, from 30%-40% currency Greece, and (c ) Greek bank refuses to lend more 8 devaluations 6 run risk rises Cut gov't spending, raise tax Begin your journey collections, enact structural back to solvency and Day of rest reforms. Then, grow at the debt sustainability same time, reducbg the debt 1 2 burden relative to GDP 3 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 Debt burden by issuer category Percent 400% • • Euro ' Greece 16% 350% - US Greece Financials 2010 15% Financials U.S. 2014E 300% • • • • Italy Ireland 14% c 250% Portugal 13% • • Canada eD 200% 12% SS 11% 150% • EM Local US Munis 10% • e 100% - • Spain U.K. 9% 50% O. France Germany 8% 0% 7% • 0% 5% 0% 15% 20% 25% 6% Interest Expense to Revenue 2005 2006 2007 2008 2009 2010 2011 Source:El. Morgan Securities LLC. OECD. Eurostat. IMF. Japan's debt Source: National Statistcal Service of Greece. burden too high to be shown. Greece bank deposits Greece car sales Euros, Billions Thousands, sa 245 30 240 25 235 20 230 225 15 220 10 215 210 205 0 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Source: Bank of Greece. Source: National Statistical Service of Greece... Morgan Securities LLC. Survey of Greece consumers: purchases of major items Greece Industrial Production over next 12 months, Percent balance, sa Index, 2005=100, sa 10 110 0 105 -10 100 -20 -30 95 -40 90 -50 85 -60 80 -70 -80 75 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Source: EuropeanCommission. 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 Bank claims on Greece 11 Percent Immediate borrower basis - Billions, USD 10 $90 French banks 9• Excludes derivatives contracts, $80 guarantees extended and credit 8• $70 commitments which amount to an 7• additional 557.9bn for France and 6• $80 Germany as of O32010 5• $50 4 $40 3 2 $30 German banks 1 $20 0 111111 . . , • .I I $10 IV% ee,be34/19/97 PP.* S44b +6% 4 70 atese 14 / 70:0/43 4 / ' $0 ea (1 4 / ? oe epee a ,9,9/ ; 1998 2000 2002 2004 2006 2008 2010 Source: European Central Bank. Source: Bank for International Settlements. 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 2.0% 2.5% 3% 2.0% 1.5% ...000• 1 0 2% 1.0% 1.0% 1% 0.5% 0.5% 0% 0.0% 0.0% 1999 2001 2003 2005 2007 2009 2011 2013 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 Source: Bloomberg. Source:M. Morgan Private Bank. European Commission. Michael Cembalest Chief Investment Officer ECB = European Central Bank; EFSF = European Financial Stability Facility: IMF = International Monetary Fund; SA = Seasonally Adjusted The material contained herein is intended as a generalmarket commenta Opinions expressedherein are those ofMichael Cembalest and may differfrom those ofothers Morgan employees and affiliates. This information in no way constitutes.. Morgan research and shouldnot be treated as such. Further. the views expressed herein may differfrom that containedinn Morgan research reports. 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