jpmorgan q&a · with spreads as wide as the 105 area. lbo activity could decrease modestly...

North America Corporate Research 19 July 2007

JPMorgan Q&A

Subprime Meltdown, the Repricing of Credit, and the Impact Across Asset Classes

US Corporate Research

Margaret CannellaAC

(1-212) 834-5528 [email protected]

www.morganmarkets.com J.P. Morgan Securities Inc.

See page 29 for analyst certification and important disclosures, including investment banking relationships.JPMorgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

This comprehensive report provides the views of JPMorgan strategists across relevant asset classes. It also includes the recommendations of our Equity Research Bank Financial Institutions analysts from the US, Europe and Asia.

• The worst is not over in the subprime mortgage market. Problems to date have been related largely to poor underwriting or weak housing prices. Credit stress related to resets of subprime mortgages will not become significant until later this year. We expect continued deterioration in subprime loan performance well into 2008.

• We think investors are overly optimistic about the potential for loan modification to prevent default. There are serious obstacles to loan modification, and in markets with falling home prices modification may not be in the interest of lenders or investors.

• Home price declines such as we expect would lead to substantial increases in subprime mortgage defaults and losses. This in turn would have significant negative implications for pricing and ratings of subprime securities and the asset-backed indices (ABX).

• Although a worsening subprime market will put some spread pressures on CLOs and therefore on leveraged loans, the net impact should be contained and relatively modest. The issues facing subprime and those facing other credit markets are not substantially interrelated.

• In equities, we think increasing defaults and delinquencies in subprime mortgages are negative for the homebuilding, banking, and retailing sectors. We are more concerned with some mid-cap and small-cap banks than large-cap financials.

• In the US high yield market, spreads are likely to remain range-bound over the next several months. With a sizeable supply backlog capping meaningful upside, but with fundamentals strong, we believe high yield bonds could trade in a range of 300 bps to 350 bps over Treasuries.

• In the US high grade market, we anticipate risk remains at elevated levels with spreads as wide as the 105 area. LBO activity could decrease modestly while strategic M&A, as well as recapitalizations and other forms of shareholder-enhancing transactions will likely increase.

• In the European credit markets, spreads continue to trade near their wides; we are of the opinion that spreads could rally, but not to their historic tights.

• In the loan market, investors may be concerned about the parallels in the subprime and corporate loan markets, and we think wider LCDX pricing at the moment reflects some of those concerns.

Global Structured Finance Research Christopher T. FlanaganAC (1-212) 270-6515 [email protected]

High Yield Credit Strategy Peter AcciavattiAC (1-212) 270-9633 [email protected]

Investment Grade Credit Strategy Edward MarrinanAC (1-212) 834-5285 [email protected]

Corporate Quantitative Research Eric BeinsteinAC (1-212) 834-4211 [email protected]

US Equity Strategy Abhijit ChakraborttiAC (1-212) 622-6519 [email protected]

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Margaret Cannella (1-212) 834-5528 [email protected]

Investment Recommendations for a Period of Subprime Meltdown and Credit Repricing Industry

Investment Recommendation

Analyst(s)

US Large-Cap Banks Losses due to subprime holdings are unlikely. We have shifted focus to an area in which large-cap banks are more vulnerable: home-equity net chargeoffs Avoid US Bancorp and National City, which have the highest proportion of home equity loans that are nonprime Favor Wachovia and Bank of America, which have little nonprime home equity exposure, although they do not disclose details

Vivek Juneja, US equity research

US Mid-Cap Banks US Mid-Cap banks do not have material exposure to subprime losses; however, there is a negative impact on their commercial lending businesses Favor "flight to quality" stocks, including Zions, as well as banks with positive catalysts, including PrivateBancorp and Synovus Avoid TCF Financial, which is thinly reserved against potential loan losses and has a high concentration of home equity loans in the Midwest

Steven Alexopoulos, US equity research

US Small-Cap Banks Small-cap banks do not generally originate or purchase subprime mortgages, and we do not expect an earnings impact from the subprime meltdown For valuation reasons, we favor BankUnited, which specializes in nontraditional mortgages and whose shares have been under pressure Among other small-cap banks, we favor Cullen/Frost in the current environment owing to the bank’s conservative credit culture and its well diversified footprint in growing Texas markets

John Pancari, US equity research

European Banks Avoid Deutsche Bank, Credit Suisse and UBS, as ABS issuance, which constitutes 10.8%, 9.1% and 3.3% of group profits, respectively, is slowing (Our Overweight rating on CSG is relative to the two other traditional IBs we cover; we underweight the group as a whole)

Kian Abouhossein, EMEA equity research

Asian Banks Avoid HSBC, as we expect the underperformance of its shares to continue as long as US earnings remain a drag

Sunil Garg, Asia equity research

This is a corrected version of our 19 July 2007 release of this note and supersedes the previous version.

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Subprime Mortgages: More Troubles Ahead for a Challenged Sector Since the first convulsions in the subprime mortgage market last February and March1, investors have been waiting for the market to hit bottom. The bottom, however, is not at hand. Credit stress around resets is largely a forthcoming problem, not a problem that has yet had great impact on securitized mortgages. We expect continued deterioration in subprime loan performance through the balance of this year, and it is likely to be well into 2008 before the problems in securitized portfolios begin to abate.

The reason for our pessimism is that loans originated in late 2005 and all of 2006, the period that saw peak origination volumes and sharply decreased underwriting quality, are only now starting to reset in large numbers. Typically, the mortgagors were able to qualify for these loans only by taking advantage of temporary “teaser” rates or by deferring repayment of principal. After an initial period, the monthly payments facing borrowers will escalate, unless the borrowers have sufficient income and home equity to refinance their loans.

Subprime delinquency rates to date, while high and rising, are largely a function of poor underwriting and weak housing prices only. The impact of mortgage resets is only now beginning to be felt. To take an example, borrowers of 2/28 adjustable-rate mortgages (ARMs) – loans that convert from “teaser” rates to rates based on current market yields after 24 months – will see monthly payments increase by an average of 30% in the next 18 months.

With credit tightening and home prices dropping in many areas, most of the borrowers of the roughly $500 billion of ARMs scheduled to reset over the next 18 months will probably be unable to refinance. Those who can not will face three choices: 1) struggle to make the higher payment, 2) qualify for a modification that will keep the rate fixed at the teaser rate, or, 3) default.

We think investors have been overly optimistic about the potential for loan modification to prevent default. The premise behind loan modification is that it may be better financially for the lender to lower the rate or make some other change to the mortgage in order to keep payments flowing rather than accept default. We think the temporary stabilization of asset-backed indexes (ABX) in April and May was due in part to optimism about the possibility of large-scale modification, and greater understanding of the difficulties involved contributed to the latest round of selling.

The difficulties involved in modifying existing mortgages are serious. Some borrowers may not qualify; for example, if the original loan was based on fraudulent reporting of income and the fraud is discovered when re-qualifying, modification would likely not be an option. Loan servicers may lack the capacity to implement modifications on a large scale, and it may not make sense for them to do so in housing markets where values are declining so quickly that rapid foreclosure may be 1. See “The Rise and Fall of Subprime: Anatomy of a Boom-Bust Cycle”, JP Morgan Q&A, 19 March 2007

Global Structured Finance Research

Christopher T. FlanaganAC

(1-212) 270-6515

[email protected]

Edward J Reardon

(1-212) 270-0317

[email protected]

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the best option. Some servicers may have sold protection in the credit default swap market and may benefit from foreclosure. In other cases, the servicer may own the equity tranche of an asset-backed security and have different interests from those of debt holders.

Further declines in home prices will exacerbate the default problem, both by making it harder for borrowers to qualify for modifications and by reducing their incentive to continue making payments on homes that are worth less than the amount owed on the mortgage. We expect that home prices, as measured by the Case-Shiller 10-city composite index, will decline as much as 15-20% from the June 2006 peak before this cycle hits bottom, potentially two or three years from now. As of April 2007, the index was down 3% from the peak, suggesting there is another 12-15% decline to go. While a total price decline of 15-20% sounds large, many markets saw prices double between 2000 and 2006, making a retreat in prices less extraordinary. Moreover, subprime heavy areas are expected to perform worse than higher end housing markets.

Home price declines such as we expect will lead to substantial increases in subprime mortgage defaults and losses. This would have significant implications for ABX pricing and ratings. For example, if prices drop 6% over the next year and then fall 3% per year for the next two years before flattening, collateral losses for the ABX 07-1 index are expected to be in the 13-14% range. This is about four times the loss rate that the rating agencies expected when they initially rated these securities. Under this scenario, the index’s BBB and BBB- tranches would be completely wiped out and the single-A tranche would lose about 50% of its principal.

While the collateral in the 07-1 index is especially weak relative to the market, the analysis implies severe rating downgrades over the next 6-12 months. If our analysis is correct, downgrades will be confronting both home-equity asset-backed securities and ABS collateralized debt obligations (CDOs that own ABS tranches from AA down to BB). Downgrades will probably reach as high as the AA part of the capital structure in both sectors.

Given these bleak fundamentals, we look for continued significant downward price pressure throughout the ABX market, as well as in ABS and ABS CDOs. Forced selling is likely to become more common, due to margin calls on hedge funds that have financed purchases, rating triggers affecting some investment vehicles, and the loss of the AAA-rated status that some holders require from a risk-based capital perspective. Some investors may simply decide the headlines are too much to deal with, particularly as litigation increases2, and may exit the sector completely. We anticipate that by late 2007 or early 2008, selling will be overdone and there will be an abundance of distressed opportunities available in the asset-backed market. Until then, however, the road will be a rocky one.

2. The Ohio Attorney General has filed suit against now-bankrupt New Century, alleging numerous violations of the Consumer Sales Practices Act, as well as the Ohio Mortgage Loan Act and the Ohio Mortgage Brokers Act, and is now preparing a case against the rating agencies for their alleged role in driving the growth of the subprime market.

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Subprime, CLOs, and Spillover Contagion from subprime mortgages is currently a key issue across the credit markets. One possible scenario involves collateralized loan obligations (CLOs). If subprime problems get out of hand, the thinking goes, CLOs will be forced to pull in their horns, causing a squeeze on leveraged loans and other types of credit. Although the worsening subprime market will put some spread pressures on CLOs and therefore on leveraged loans, we think the net impact will be ultimately contained and relatively modest.

A CLO is a special-purpose vehicle that purchases various types of loans, divides its pool of loans into tranches with varying risk characteristics, and then sells those tranches to investors. CLOs do not hold subprime mortgages; these are commonly held by ABS CDOs, a different asset type. But CLOs are extremely important participants in the leveraged loan market. We estimate that CLOs own approximately $300 billion of leveraged loans, representing about three-fifths of all leveraged loans outstanding in the US market.

CLOs’ underlying assets remain very healthy. Strong corporate profits continue to generate exceptionally strong high yield credit performance. Nonetheless, the initial subprime sell-off in February led to a spike in CLO volatility. CLO spreads stabilized in May but have been widening since early June. Lower-rated tranches – the tranches most exposed to loss in the event of problems with the underlying loans – have predictably performed worst in a nervous market. Spreads on the top-rated tranches – the securities least exposed to credit losses – have barely moved (Table 1).

Table 1: Indicative US CLO spreads (bp) and estimated mark-to-market losses Spreads AAA AA A BBB BB 02/15/2007 23 39 70 140 340 07/05/2007 24 52 120 275 525

Est. Duration 4.5 yr 4.75 yr 5 yr 5.5 yr 6 yr Est. MTM ($) -0.05% -0.67% -2.50% -7.43% -11.10%

Source: JPMorgan

In our view, this apparent “contagion” stems principally from technical factors and from a general repricing of risk across the credit markets. We do not believe that the credit fundamentals of subprime mortgages and leveraged corporate loans are directly interdependent. In contrast to leveraged loans, subprime fundamentals are exceptionally poor.

The technicals deteriorate The credit fundamentals in the corporate loan market remain solid. The earnings of high-yield borrowers (see following sections) are growing strongly, providing ample resources to service debts. Defaults in the leveraged loan market are few and far between. The credit quality underlying CLOs is thus dramatically better than the ABS CDOs that invest in subprime mortgages.

However, while US leveraged loan performance remains quite good, investors are starting to shown signs of nervousness. Issuer leverage has been creeping higher, and is currently at 5.1x total debt/EBITDA, only slightly below the average level of 5.2x during the 1990s. Many investors are convinced that loss rates will revert to historical norms by 2008 or 2009, and are factoring this into their cash flow analysis. Numerous borrowers have been seeking loans with few or no covenants to


Christopher FlanaganAC

(1-212) 270-6515

[email protected]

Kedran R Garrison

(1-212) 270-0137

[email protected]


Christopher FlanaganAC

(1-212) 270-6515

[email protected]

Kedran R Garrison

(1-212) 270-0137

[email protected]

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protect investors from changes in control or corporate actions that would increase leverage. In several such cases in the past few weeks, we have seen investor pushback, and borrowers have been forced to agree to covenants in order to obtain their loans.

Technical factors in the market, however, are increasingly negative. The loan pipeline is massive. According to S&P, LCD $216 billion of leveraged loans await issuance, as investors increasingly insist on more buyer-friendly spread levels and structural protections.

The markets have been asked to accommodate this supply at a time of unusually tight spreads. For example, US BB leveraged loan spreads were near all-time tights of 160bp in March, pushing modeled CLO equity returns near all-time lows (9-10%) – CLO equity returns are generated by the difference between the risk-adjusted asset spreads and liability spreads of the CLO. Fundamentally, even at current CLO liability spread levels, leveraged loan spreads need to widen to restore CLO equity arbitrage to more palatable levels. If CLO spreads were to widen further, additional loan spread widening would also be required.

In our view, one part of what is “bothering” the CLO market is less credit spillover from subprime than investor expectations of more historically normal leveraged loan performance going forward. This implies that there is probably room for CLO spreads to widen further in both the US and Europe, especially if defaults rise. In this respect, we point to Movie Gallery’s recent covenant violation and ratings downgrade; Movie Gallery was the 30th-largest exposure in our 2006 CLO overlap study, comprising 0.5% of total collateral3. However, if issuers are less aggressive when it comes to demanding more generous financing terms (cov-lite, etc.), there may be less pressure for wider spreads on leveraged loans.

Liquidity and “contagion” Subprime market technicals are potentially having the largest immediate impact on the CLO markets. On the long side, we do not think there is much direct client overlap, particularly in the fast money client base, but on the short side, macro hedge funds are looking for the next cheap short, and, in terms of liquidity generally, dealers appear to be tightening credit lines.

CLO market participants include banks and bank funding vehicles, monoline reinsurers, insurance companies, pension funds and endowments, institutional money managers, hedge funds, high net worth clients (often via CDO equity funds), and increasingly, CDOs themselves. Risk is distributed globally, although European investors tend to be skewed towards senior positions. Asian investors seem to be taking more of the mezzanine to equity, especially in ABS CDOs backed by subprime. In general, we think the CLO investor base is more diverse and relatively more real-money oriented compared to investors in ABS CDOs. This makes sense, as CLO structures and collateral are arguably more straightforward to analyze, with less of a need to “look through” to underlying mortgage pools and to consider servicer risk.

3 “Completing Our Global CLO Concentration Study: US CLO Overlap, Take Two”, JPMorgan Research, April 20, 2006.

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Approximately three-quarters of US CLOs have AAA ratings. These CLO tranches have little risk of default absent an extreme deterioration of market conditions. The 8% of CLO assets held in equity tranches, on the other hand, will quickly be affected if the underlying loans become delinquent.

Table 2: Sample global CDO capital structures and market weights US Mezz ABS

CDO US HG ABS

CDO US HY CLO Europe HY CLO

AAA 77% 93% 75% 67% AA 8% 3% 5% 8% A 5% 2% 5% 7% BBB 4% 1% 4% 6% BB 1% 0.5% 3% 2% Equity 5% 0.5% 8% 10% 2006 Notional 109.9bn 292.1bn 113.3bn 60.7bn 2007 Notional 55.1bn 73.7bn 58.3bn 23.8bn Source: JPMorgan. As of July 9, 2007.

Our estimates of market participation are rough but help quantify the likelihood of forced selling (Figures 1-6). In terms of market and ratings sensitivity, CDO managers and CDOs are perhaps the most insulated. CDOs are designed to take long-term credit risk, and managers typically retain equity to align interest with other equity investors. CDO trading becomes constrained (but not mandated) after collateral downgrades; also, CDOs do not typically unwind based on market value measures4. However, issuance is down dramatically in Q2, meaning that a portion of the CDO buyer base is gone (about 10% of the total, but 30-50% of subordinate paper), contributing to spread widening in both ABS CDOs and CLOs.

Banks, monolines and insurance companies form the bulk of total volume (we estimate around 75-80%) and are not particularly mark-to-market sensitive. They are, however, generally ratings sensitive, especially at the mezzanine portion of the capital structure. Subprime downgrades need to be extensive (e.g., 35% of collateral downgraded 2 notches or more) for investment grade ABS CDO paper to merit downgrades to junk5, but we think many ABS CDO BBBs will get to this level within the next 3-6 months, a process which has already started (S&P and Moody’s have placed numerous tranches on watch following subprime ABS downgrades). This should lead to another round of selling in the market, with continued negative press coverage further accelerating the selling. SIVs and HG SF CDOs may also be incentivized to sell assets if they need to roll senior short-term financing.

Hedge funds (estimated around 10% of total volume) are the most market sensitive, particularly if buying on leverage; they have been active long-short players, and while some have made money, others are at risk of liquidations. Massive liquidations at certain rating levels have resulted in ABS CDO spreads gapping out, with expectations of more to come.

4 See JPMorgan CDO Monitor, March 15, 2007 5 CDO Monitor, March 15, 2007

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Approximate CDO market participants by rating level Figure 1: AAA

0 20 40 60 80 100

Banks/ Monolines

Insurance

SIVs/ HG SF CDO

Hedge funds CLO

SF CDO

Figure 2: AA

0 20 40 60 80

Banks/Insurance

HG SFCDOs

Hedgefunds

CLO

SF CDO

Figure 3: single-A

0 20 40 60 80

Banks/Insurance

HG/ MezzSF CDOs

Hedgefunds

CLO

SF CDO

Figure 4: BBB

0 20 40 60

Banks/Insurance

Mezz SFCDOs

Hedgefunds

CLO

SF CDO

Figure 5: BB

0 20 40 60

Banks/Insurance

CDOManager

Hedgefunds

CLO

SF CDO

Figure 6: Equity

0 10 20 30 40 50

CDO Manager

Pension

Bank/ Equity funds

Hedge funds

Insurance CLO

SF CDO

Source: JPMorgan Liquidity Liquidity in the subprime sector has evaporated, with feedback effects to CLOs. Again, on the long side, we do not necessarily think that there is large client overlap between ABS CDOs and CLOs, more that a) some buying powder has dried up and b) dealers have tightened credit lines in reaction to market volatility (more so in subprime sectors but also in CLOs)6. For instance, a CLO buyer able to purchase a AAA CLO on repo 12 months ago, posting 2.5% margin, could now be required to post 5%. This makes it marginally more difficult for dealers to place paper, and can lead to collateral / CLO liability spread widening. This is potentially the greatest risk 6 “US Fixed Income Markets Weekly,”June 29, 2007, pgs.59-61.

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of contagion from subprime into CLOs and ultimately into leveraged loans – the inability for the marginal investor to attractively finance purchases of the CLO liabilities.

On the short side there is more client overlap, namely from macro hedge funds. After making profits on ABX shorts in Q1, these clients looked for cheap shorts in other levered credit products: there was a noticeable increase in CLO short interest in March and April, picking up again recently (Chart 7 and 8). Underlying CLO fundamentals had not changed, but moderate activity in thin markets makes significant noise. Further, with the launch of LCDX (a basket or index of 100 loan credit default swaps, similar to the CDX or ABX indices available for corporates or ABS), leveraged loan and CLO dealers began hedging swelling pipelines, pushing out LCDX spreads. Loan spreads have widened but not enough to match the LCDX move, heightening the perceptions that loan and CLO spreads have further room to widen.

The reaction to these spread moves by traditional CLO investors has been mixed, with some viewing this as an opportunity to buy paper at more attractive levels with less competition. For instance, some European CLO investors have allocated more funds to US CLOs recently, perceiving fundamental subprime spillover as contained and looking to take advantage of market illiquidity. Still, most long investors are waiting for some stability before stepping back in. Others are more negative and are increasingly holding back or looking to hedge exposures via LCDX. Lastly, the relentless negative press regarding subprime mortgages and ABS CDOs (in some cases, conveying misleading or inaccurate information) increases the prospect of some investors freezing CDO investments completely, regardless of credit quality or asset class; we have heard of several such instances at various levels of the capital structure and expect more to follow.

Figure 7: Secondary List Volume, Mezz and HG SF CDOs $ bn

-2.0

0.0

2.0

4.0

6.0

8.0

2006-07 2006-10 2007-01 2007-04 2007-07*

Long Short

Source: JPMorgan. *Volume through July 12, 2007

Figure 8: Secondary List Volume, HY CLOs $ bn

-2.0-1.5-1.0-0.50.00.51.01.5

2006-07 2006-10 2007-01 2007-04 2007-07*

Long Short

Source: JPMorgan. *Volume through July 12, 2007

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Repricing continues, for now The combination of market volatility and the credit reminder from subprime has led to a greater sensitivity to risk, pressuring CLO mezzanine and subordinate tranche pricing. We have moved from a Neutral to a tactical Underweight allocation on US7 and European8 CLO mezz/sub debt in recognition of challenged liquidity conditions.

In our opinion, this re-pricing is healthy, given where we are in the credit cycle. In a similar fashion, it is also healthy to have increased pushback on issuer-friendly structures. However, we do not think that the CLO market merits the same amount of price activity as seen in subprime. The combination of fraud, massively overleveraged consumers, new and untested loan products, and the bursting of the real estate bubble produced the unusually dramatic subprime conditions. CLOs are in a similar situation only in the sense that a glut of global liquidity and good borrower performance have led to less stringent underwriting and more issuer-friendly features.

Conditions in the CLO market are not nearly as severe as those in subprime. Indeed, it would be far more difficult for leveraged loan issuers to flat-out lie about income levels (as in many subprime no-documentation loans). CLO structures are simpler and more intuitive (principal generally goes in order of priority, not reverse order pending triggers).

Ultimately, perhaps by the end of the summer, we think the fear spillover from subprime into CLOs and loans will abate and investors will find newly attractive valuations relative to what is still a positive fundamental outlook for corporate risk.

7. “Global CDO Weekly Market Snapshot”, July 2, 2007. 8. “Global CDO Weekly Market Snapshot”, July 9, 2007.

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High-Yield Credit: Subprime’s Not the Problem Six weeks ago the high-yield market was breaking records. Since then, all the news has been negative. What’s going on? The credit markets have indisputably had a tough month. On June 5, the JPMorgan High-Yield Index reached its historical tight of 263bp over Treasuries. Since then, it has widened by 70bp. Despite the headlines, though, I don’t think this has much at all to do with the problems of subprime mortgages. The high-yield market has some issues of its own, principally related to an unusually large forward calendar. I think these technical issues, not subprime, are responsible for the market backing up. Can you describe the technical issues you think are weighing on the market? For one thing, there’s a record forward calendar. We had nearly $15 billion of high-yield bonds attempting to price at the very time volatility in interest rates and equities was rising. Some of this scheduled issuance was extremely aggressive. For example, the calendar included three credits with more than 9x leverage, and there were seven bonds with “toggle” provisions that would allow the issue to pay interest with additional bonds rather than cash. And many of the proposed issues came with very lax covenants to protect bondholders from future actions by the issuers. These types of deals came on to the market amid the collapse of two hedge funds that invested in subprime mortgage debt and other negative news. Investors simply said no. They demanded higher yields and greater protection. Frankly, I think it was a very healthy development. The markets were becoming excessively exuberant, and I think these recent developments reflect a much more healthy view of potential risks. Is the spread widening in high yield over for now, or is there more to come? There may well be more. My concern is the enormous shadow calendar – we estimate a potential $100 billion of high-yield bond issuance over the next few months. Most of this expected issuance is related to leveraged buyouts, and we expect issuers to attempt to price their bonds very aggressively. The timing of that issuance, though, is anyone’s guess. If the issuance is spread out, the market should be able to handle it without too much difficulty. If several big issues come to market at once, however, spreads may have to rise. As it stands, the rest of July will see relatively little new issuance, but August could be unseasonably active. On the shadow calendar are a host of sizeable acquisition-related deals. Among them, we expect to see First Data Corporation ($8 billion), Clear Channel Communications ($4.5 billion), Biomet Inc. ($2.5 billion), and Affiliated Computer Services ($2.5 billion). Given the large calendar, investors are now in the driver’s seat. I expect that investors are going to continue to demand greater protection and higher compensation on future deals. Buyer selectivity is likely to remain high. I would not be surprised to see a number of proposed issues withdrawn and revised as investors demand less aggressive structures and greater covenant protection. That said, a strong economy and low default risk limit downside risk. Year to date, only four high-yield companies have defaulted. If this pace continues, 2007 will have fewer defaults than any year since 1981. Expected earnings growth of the S&P 500 is being revised upward, which is a positive sign for credit quality.

High-Yield Credit Strategy

Peter AcciavattiAC

(1-212) 270-9633

[email protected]

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What about the upside? While we surmise high-yield bonds are approaching levels at which buyers will become interested, we believe a sustainable near-term rally is unlikely. In recent years, corrections in high yield have been short-lived. However, we think this time will be different, as any market rally is likely to be met by new issuance. This time last year, the high-yield market had an estimated $51 billion supply deficit. Now, the supply deficit is only $9 billion or so. The shift from excess demand to excess supply has been driven by the surge in new issue volume and a decline in redemption activity. This technical situation limits the ability of the market to advance for a sustained period. How do subprime concerns factor into this? We think that the weakness of the housing market – not just subprime defaults – will likely cap monetary action. We do expect the Fed to tighten policy again around the end of the year, but we don’t think it will move far. The combination of sustained growth and limited Fed tightening would be positive for high yield. I don’t expect direct spillovers from subprime concerns to the broader credit market. There are a number of contagion scenarios out there. For example, hedge funds and CLOs could be forced to liquidate leverage loans or high-yield bonds in order to cover losses on subprime mortgages. I don’t see any evidence of this occurring. Investors seem very able to make appropriate distinctions among various types of credit, and to act accordingly. So your overall outlook is modestly upbeat? Spreads are likely to remain range-bound over the next few months. With a sizeable supply backlog capping meaningful upside, but with fundamentals strong, we believe high-yield bonds can trade in a range of 300bp to 350bp over Treasuries. We would find spreads around 375bp enticing, and spreads of 400bp would make us aggressive buyers under present conditions.

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Investment Grade Credit: The Story Is Event Risk Event risk has made the high-grade market difficult over the past few months. Could the problems in subprime lending actually help the investment grade asset class by making it harder for financial sponsors to pull off leveraged buyouts? I do not see any signs at all that event risk is abating. It is true that yields in the leveraged loan market and in the high-yield bond market have backed up, making it more expensive for buyers to finance leveraged transactions. However, in my view, there is still ample financing available for such transactions even if the credit markets are in the midst of a repricing of risk. Many of these LBOs were agreed six months or more ago, when all-in yields were similar to those in force at present. The fact that credit spreads have widened from their historical tights does present some challenges for the pending buyout financings. All the evidence we see is that interest in go-private transactions and in M&A activity remains high, and the investment grade asset class will continue to face risks as a result.

How are investment grade investors protecting themselves against event risk? Over the last 18 months, the inclusion of change of control covenants in investment grade bond issues has become quite common, largely as a response to the spate of LBOs which has rendered many bondholders unwitting (and definitely unwilling) investors in high yield securities. To be sure, such COC provisions have provided credit investors with a meaningfully improved degree of financial protection against the rising tide of private equity and M&A activity, which has been the primary source of credit-unfriendly event risk during this credit cycle. Having clamored for better covenant protection as the go-private phenomenon gathers momentum, credit investors can finally point to something more tangible than just a moral victory in their perennial battle with shareholders over claim to the assets on the corporate balance sheet. However, recent events at companies that have issued COC bonds -- Home Depot (leveraged share buyback) and Alcoa (unsolicited acquisition proposal for Alcan) remind us that while change of control language can help protect investors against highly leveraged take-over, there are plenty of other “events” designed to enhance shareholder value (at the expense of bondholders) for which change of control protection is essentially meaningless. As a result, there has been increasing talk (but a lot less action) on the corporate issuance of bonds with coupon step-ups triggered by rating downgrades. To date, only a handful of bonds with such provisions have been issued as issuers have shown stiff resistance to offering such further protection. This subject may be the next structural battleground for issuers and credit investors as the event risk cycle continues. What other issues are relevant at this stage of the event risk cycle? Credit investors should take note of at least a few important trends unfolding in the corporate sector. First, while we anticipate that M&A activity will continue at its furious pace, we expect the form of such activity to change from private equity-led M&A to an increased volume of strategic M&A by corporates. We think it reasonable to expect that private equity will take a breather from its torrid pace of acquisition to digest the assets and businesses they now own; the back-up in interest rates and widening of credit spreads and the prospective logjam surrounding leveraged finance are other good reasons to expect some moderation in the pace and volume of private equity M&A. Second, we believe that a wider range of companies

Investment Grade Credit Strategy

Edward MarrinanAC

(1-212) 834-5285

[email protected]

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are considering more diverse and creative strategies to unlock value on their balance sheets and maximize shareholder returns. Leveraged recapitalizations, transformative M&A, break-ups/divestitures, whole business securitizations are all possibilities. If we are correct in this view, credit investors might want to remain alert for more dramatic changes in corporate credit risk profiles and a rise in succession events in the CDS market.

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Lessons from the Loan Market If subprime problems are contributing to a pullback in credit, we’d expect to see the impact on the loan side. How do we really know what’s going on there? We have a new product that’s proving surprisingly useful in shedding light on the loan market. It’s a derivative product called the Loan CDX index, or LCDX for short. This is a traded index that was launched on May 22, and it’s designed to allow investors to establish long or short credit risk positions in the US high-yield loan market. Basically, rather than buying pieces of numerous loans, investors can take exposure to 100 credits in a single transaction with low transaction costs. The index price is not directly based on the value of the loans, or of the underlying loan credit default swaps that make up the LCDX portfolio, but is set by the supply and demand of the market. This is analogous to the pricing of a closed-end mutual fund, whose traded price is based on the buying and selling of the index, not on the net asset value of the underlying securities.

So how is the LCDX performing? The LCDX has definitely been trading down. When the index began trading on May 22, it was priced above par, near $100.50. It is now trading at $95.75, a fall of almost 5% since its launch. Most of that decline has occurred in the past two weeks. Over that period, the LCDX has greatly underperformed both equities and the cash high-yield market (Figure 9).

Figure 9: A Rocky Start for the LCDX

95

96

97

98

99

100

101

102

103

22-May 29-May 5-Jun 12-Jun 19-Jun 26-Jun 3-Jul 10-Jul 17-Jul

Source: JPMorgan.

Corporate Quantitative Research

Eric BeinsteinAC

(1-212) 834-4211

[email protected]

Andrew Scott, CFA (1-212) 834-3843

[email protected]

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What’s the reason for the LCDX sell-off? I don’t think there’s a single cause, but there are three factors that seem to be involved. First, and most importantly, the decline is probably related to expectations of new issuance. The forward loan new issuance calendar increased from $132 billion on May 16 to around $215 billion now. Dealers underwriting the new issues may be buying protection (short risk) through the LCDX as a hedge against potential negative moves in the credit markets. Second, LCDX is a useful product for investors who own cash loans and want to hedge. LCDX is now trading at tighter spreads than cash loans, because it offers better liquidity and has lower trading costs and a longer expected duration. Suppose you own loans and think that there may be trouble in the market, because of the large new issue calendar, borrower defaults, or some other reason. You could sell your loans, but this is fairly expensive in a market with high transaction costs. Alternatively, at present LCDX levels you can hold on to your cash loans, continuing to collect the interest, while going short risk in the LCDX market. This is a simple carry trade, and for many investors it makes sense given the relative spread levels. However, it’s important to point out that this trade is not an arbitrage, as cash loans and LCDX have different risks. In particular, cash loans can be called at par at any time, but the calling of any individual loan will have minimal effect on the LCDX Third, the increased popularity of collateralized loan obligations (CLOs) is probably contributing to the decline in the LCDX. CLO arrangers typically accumulate a portion of their portfolio of cash loans before they begin marketing their transaction. There is now a very large number of CLOs in the pipeline, and the arrangers are exposed to credit and market risk after they have started to accumulate assets and before they distribute the CLO to investors. LCDX offers one way of hedging the risk that the value of these loans will fall before the CLO is distributed. So we think that many CLO arrangers may be selling the LCDX (short risk) to reduce their market exposure. Is the LCDX cheap? Yes, it’s cheap given our strategists’ view that default rates should remain low and the economy should strengthen. But it is likely to become cheaper because of more technical reasons; the loan new issue calendar looms, as does uncertainty about the re-pricing of CLOs. In our opinion, there are two primary benchmarks investors will use to consider this question, 1) the CDX High Yield and 2) cash loans. First, the CDX HY is a derivative index that follows the high yield unsecured bond market. The biggest difference between the LCDX and CDX HY indices is the expected recovery rates of credits following a credit event. In other words, secured loans should recover at higher rates than unsecured bonds if a company files for bankruptcy. Observing about 15 years of historical data, bond investors have lost 2.2x as much as loan investors, on average (standard deviation = 0.6). Thus, a reasonable benchmark is to say the CDX HY spread should be 2.2x more than the LCDX spread. Currently, the CDX HY spread is approximately 1.8x the LCDX spread, well within the historical range. Second, the LCDX should probably not provide larger returns than a portfolio of cash loans. As mentioned previously, cash loans are more expensive to fund and trade than derivatives. As a result, cash loans need to pay investors more than

17



derivative loan contracts to compensate investors for additional costs, and for additional risks, such as the risk of being called (derivatives may be “called,” but the risk is smaller). Investors may prefer investing in derivatives if LCDX returns become equally or more attractive than cash returns. Currently, cash loan prices are re-pricing towards the falling LCDX. Does the LCDX sell-off shed any light on investor expectations concerning subprime mortgages? Only indirectly. The LCDX is based only on corporate loans, not on mortgages. Corporate loans, in general, have been performing very well, and default rates are low, so there is no imminent fear of major problems. That said, investors in the loan market are very aware that the subprime mortgage market went through a period during which credit standards were very loose, requirements for downpayments were minimal, and lenders made extremely aggressive assumptions about borrowers’ ability to service their debts. The corporate loan market went through a similar loosening of standards, in some cases involving extremely high leverage, lower equity participation in deals, easing of loan covenants, and very aggressive CLO structures. So investors are concerned that there may be parallels in the subprime and corporate loan markets, and I think LCDX pricing at the moment reflects some of those fears.

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European Credit: A Spot of Indigestion How are American subprime mortgage problems being felt in Europe? In the European structured finance market, the impact to date has been squarely on the technical side, with contagion limited to its impact on already jittery investor sentiment rather than fundamental performance. Irrespective of European jurisdiction and underlying assets, spreads have stepped out wider across the capital structure as risk reduction becomes the theme of the summer. Certain sectors have, however, received the majority of negative attention — UK non-conforming and Spanish RMBS and CMBS, and corporate CLOs, which have all experienced noticeable widening in spreads, particularly in the junior tranches.

We believe Financial institution exposure to subprime remains largely a US issue, with some notable exceptions such as HSBC or UBS. We expect larger traditional US banks to feel some pain, but think any real problems will be confined to second-tier regional firms. European Financial exposure is likely to come mostly from investing in these products, rather than originating or distributing them. As we wrote in European Credit Outook and Strategy (November 2006), with the importance of leverage investors higher and banks more interlinked, a lock-up in one market like subprime could potentially cause contagion remarkably quickly.

What about the nervousness in other US credit markets? Is this having ramifications in Europe? The $300bn US high yield and leveraged primary market pipeline has seen a (more modest) re-pricing of European leveraged loans and high yield bonds.

Are you prepared to add risk at this time? Yes, we are still looking at markets from the perspective of adding, rather than reducing, risk. We do not see a credit problem, at least a corporate credit problem. Our concern in the short term is that the things the market needs to see to stabilize and rally — Alliance-Boots getting done, that the US loan market has sufficiently re-priced to clear the forward calendar, etc. — will not be evident for potentially another 3-4 weeks, possibly longer. Given this, we believe this is a trade that one might have to “wear” a while, and wear in an environment where mark-to-market volatility is set to remain elevated a while longer.

European Credit Strategy

Stephen DulakeAC

(44-20) 7325 5454

[email protected]

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Equity Market Fears a Credit Squeeze How will the problems in subprime mortgages affect stocks? The problems facing subprime and the housing sector more generally are unlikely to threaten the US economic expansion, but we do not believe that the impact will be completely contained. In our view, increased write-offs due to mortgage defaults will bring higher provisioning by the banking sector, driving tighter credit standards. The most significant equity-market impact of tighter credit and reduced risk tolerance will be at the individual sector level, but as with previous episodes when concerns surrounding subprime have surfaced, the broader market is unlikely to go unscathed.

To date, we have been surprised at how well equities (and financial markets in general), have absorbed deepening concerns surrounding the housing and sub prime/Alt-A mortgage markets. Our primary concern for equities stems from the fact that the risks facing housing and broader credit markets and ultimately equities cannot be disentangled, as has been seen on many days when subprime fears have reared their head.

What happens if subprime concerns lead to tighter credit? If the mortgage situation were to lead to credit tightening, clearly the support that buyout activity has provided for the equity market could weaken. Additionally, it is unlikely that the broader market would continue to rally if risk tolerance were to diminish. In isolation, we would not see a slowdown in M&A activity as a major concern for equity market valuations; multiples for the S&P 500 have declined over the past few years despite a lively merger market. However, in the face of low-single-digit earnings growth, limited headroom for valuation expansion (the S&P is trading at 18x historic reported earnings, versus a 60-year average of 16.5x), and continued high energy prices, the equity market would clearly be at risk of losing a key support at a time when broader headwinds are intensifying.

What sectors would be most affected? Tightening of credit standards would most likely drive further write-offs of inventory and land holdings by the Homebuilders. We still believe the magnitude of impending write-offs has been underestimated. Although shares of the six major Homebuilding companies have fallen an average 50% from their peaks in 2Q05, we think further write-downs will force another leg down in prices.

We are confident that the Financial sector (particularly Banking) is not vulnerable to a crisis such as that of the early 1990s, when commercial real estate delinquencies became a critical problem. However, further deterioration in non performing loans will result in a significant hit to earnings for the sector, which currently are estimated to grow only at a low single-digit rate this year. We estimate that if serious delinquencies rise 50bp for prime mortgages and 200bp for subprime mortgages, Banks’ net income would fall almost 10% from their 2006 levels. This scenario is not factored into prices at present, in our view.

Additionally, within the Financial sector, we are concerned that the amount and leverage of structured products owned by brokers, mutual funds, hedge funds, endowments and insurance companies remain unknown. There are potential negative consequences for share prices as losses are recognized and revealed. We note that many investors have been slow to disclose losses, at least in part because some of the

US Equity Strategy

Abhijit ChakraborttiAC

(1-212) 622-6519

[email protected]

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instruments are difficult to value. However, as some investors admit to losses on mortgage-related securities, others will come under increasing pressure to do so.

The other direct area of concern is the Retail sector. June retail sales came in well below expectations. Recent warnings by Home Depot and Sears and evidence of aggressive discounting raise further downside risk for the sector, particularly if there are signs of weakness in employment and income growth. Furthermore, we believe consumer spending has held up as higher equity prices have offset declining house prices. This may not prove to be the case if the feedback loop from housing and tightening credit markets plays through.

Can stocks rally from here? Overall, we believe that the equity market – up close to 10% for the S&P 500 – has shrugged off the risks that are impacting the housing and credit markets. However, the rally has left little cushion if we see any further deterioration in these markets. The catalysts required to prolong the rally – declining bond yields, a Fed rate cut, a material improvement in housing starts or prices – are all low probability events in the next six months, in our view.

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US Large-Cap Banks Are the banks in your universe seeing significant fallout from subprime mortgage defaults? The banks in our universe are not large holders of subprime first mortgages. While residential loan foreclosures and non-performing mortgages are both increasing rapidly in the industry, we believe credit losses on subprime mortgage loans and earnings impact from overall subprime mortgage business will be manageable by large-cap banks due to the limited exposure to subprime, use of insurance, better underwriting, and diversified earnings.

If anything, concerns about how the subprime situation will affect large-cap banks have lessened as several weak independent mortgage originators have disappeared and origination volumes have slowed. The larger diversified banks and broker dealers have managed through this period with limited negative impact on earnings. Those that suffered losses managed to offset most of the impact through trading gains and one-time gains. Some large regional banks have seen some pressure on earnings but seem likely to get through this contraction. The larger banks are judiciously gaining share in this market shift.

What about originations? Year-to-date, subprime mortgage volumes are down about 30% from 2006 for the industry but likely down at a lesser rate at the larger banks. Volumes are likely to decline further. Some of the specialist subprime originators have exited, and we expect others to do so. When the dust settles, we think that the big banks will have a much larger share of the subprime business than they did during the go-go years but with more conservative underwriting standards.

Where else should we be looking for problems? Large-cap banks will see some further increase in credit losses from subprime mortgages as home prices decline further, but it should be manageable. This is because large-cap banks have kept better quality subprime mortgages on balance sheet, most of our banks have avoided multiple risk layering, some have bought mortgage insurance, and none of our banks has kept significant residual exposure or CDO exposure. Any analysis that treats large-cap banks’ subprime mortgage exposure similar to the rest of the industry on an overall basis is ignoring these critical factors, although there are wide variances among banks.

There has also been some slowdown in residential construction lending in some markets and modest increases in losses to homebuilders, but large-cap banks generally have not seen much pressure as they are more diversified and have limited this exposure, especially the larger diversified banks.

There will likely be greater impact on the larger diversified banks if subprime related fears have a bigger impact on the leveraged corporate lending market, as it could slow capital markets volumes and fees significantly and increase commercial loan losses. Some of the more sophisticated large banks have put on some protection against these credit losses also via the CDS market.

Large-Cap Banks Equity Research

Vivek JunejaAC

(1-212) 622-6465

[email protected]

Note: Companies listed in these tables are covered by JPMorgan equity analysts and addressed in our analysts’ comments. Stock ratings: O/W – Overweight N – Neutral U/W – Underweight Stock prices are as of the close, 17July07 Equity Recommendations Bank of America (BAC—$49.80) O/W Citigroup (C—$52.46) O/W Fifth Third (FITB—$40.65) U/W National City (NCC—$33.05) N SunTrust (STI—$89.38) O/W U.S. Bancorp (USB—$32.87) N Wachovia Corp. (WB—$52.36) O/W Wells Fargo (WFC—$35.59) O/W

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We expect home equity losses to be more at risk and rise faster due to the fallout from subprime business that is pressuring home prices, and some large banks have added to reserves for these loans. Subprime home equity will be far more vulnerable but is a very small portion of exposure at the larger diversified banks. It is a bigger piece of some large regionals but still relatively small and likely manageable. Home-equity net charge-offs have picked up in the past two quarters from extremely low levels and have risen faster at banks that have greater exposure to the Midwest, where local economies are weak, and recently in other markets where home prices are falling. Delinquencies also appear to be rising faster on home equity loans made in 2006 as the downturn in home prices has left some borrowers in a negative equity position.

Home-equity loans and lines of credit constituted over 29% of residential real estate outstanding on balance sheet at banks and thrifts at March 31, 2007. Growth has slowed in the industry overall since 2005, but lending by the larger diversified banks has grown at a much faster rate than the overall industry. However, two large regionals, US Bancorp and National City, have the highest proportion of home equity loans that are nonprime, which includes subprime. However, USB had a 9% year on year decline in subprime home equity in 1Q07 and NCC has decreased its subprime home equity assets by 46% year on year as it lets the portfolio run off. NCC also has some mortgage insurance protection on nonprime home equity. We believe that WB and BAC have very little nonprime home equity, but they do not disclose details. Citi had the fastest home equity loan growth in ‘05/’06, which increases its risk, and losses are rising, but it has added to reserves in 1Q07, has good FICO mix, and is more diversified (Table 3).

Table 3: Nonprime Home Equity at Large-Cap Banks Average balance as of 1Q07

Nonprime Total H.E. % Nonprime Chg in Nonprime HE H.E. ($ mil.) ($ mil) of Total HE QoQ % YoY %

BAC NA 89,561 NA NA NA

C1 2,000 64,441 3.1% NA NA

FITB NA 12,072 NA NA NA

JPM1,2 1,500 85,730 1.7% NA NA

NCC2 2,070 14,322 14.5% -7.8% -46.0%

STI2 673 14,040 4.8% 18.8% NA

USB 1,871 15,555 12.0% -1.7% -9.0%

WB NA 59,602 NA NA NA

WFC 944 69,079 1.4% -13.8% NA

Source: Company reports. 1. Data as of 4Q06 for C and JPM. 2. Data is based on period end for JPM, NCC, and STI.

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There is now much talk of lenders modifying the terms of existing subprime loans. Do you think this will occur, and how would it affect the companies you cover?

Loan modifications have started. These include short sales as well as reduction in interest rates or other changes in terms. Modifications will likely have a significant impact on defaults and therefore losses. However, there is a lack of visibility on this subject, including the criteria that lenders use in agreeing to modification.

The impact of loan modifications on lender profitability is highly uncertain. We have seen one study of delinquencies in the early 1990s, which found that in markets with rising prices, 20% of the troubled loans needed to be cured (i.e., never to default) in order for modification to be a break-even proposition for the lender or investor. In markets where prices were falling, however, 40% of the troubled loans needed to be cured for modification to pay off. As house prices are falling in many parts of the country, lenders are likely to find that modification is not worthwhile in many instances. Continued price declines will interfere with modification.

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US Mid-Cap Banks The mid-cap banks aren’t big subprime lenders. How are the problems in subprime affecting them now? The subprime fallout has a two-pronged effect on the banks in general: a consumer impact and a commercial impact. On the consumer lending side, subprime borrowers are having more difficulty meeting their financial obligations, which has caused a meaningful increase in the percentage of subprime mortgage loans that are in default. None of the mid-cap banks in our coverage universe has a material exposure to this type of loss. The more meaningful impact to the mid-cap banks from the subprime fallout is on the commercial side. What are you seeing with respect to commercial lending? This subprime credit crunch has exacerbated downward pressure on the housing market. Sales of new single-family homes fell to seasonally adjusted annual rate of 915,000 units in May 2007, down 15.8% from a year earlier, marking the 18th consecutive month of year-over-year declines. In addition, the supply of new homes for sale is up about 38% from a year ago, with each home on the market for about 5.7 months, two months longer than a year earlier. Rising inventory levels and slowing home sales are placing incremental pressure on land acquisition loans (which finance the purchase of raw, undeveloped land), land development loans (which finance activities to prepare land for building), and residential construction loans (which finance the physical construction of homes). In total, these three types of loans represent about 15% of total loans on average for the mid-cap banks. Builders are now strapped for cash, sales of developed land have dried up, and land acquired for development projects is finding a few buyers. The result is that banks are moving more of these credits to nonperforming status. In addition, of course, banks are suffering a loss of income because they are originating fewer of these loans. How do investors in your sector play current worries about credit quality? With the operating environment becoming more of a challenge for the mid-cap banks, we continue to recommend that investors position in “flight to quality” names, such as Zions. So far as other names are concerned, we think catalysts will be required to cut through the noise of a difficult operating environment. In terms of names with unique catalysts, we recommend PrivateBancorp and Synovus. For PrivateBancorp, we believe a shift in sentiment from negative to positive tied to a turn in key fundamentals including margin, loan growth and credit quality is going to be the driving catalyst. The unique catalyst that we look for at SNV is an eventual spin of TSYS, which we think unlocks 8% to 11% of embedded value. We continue to recommend that investors stay Underweight TCF Financial, which is thinly reserved against potential loan losses and has a high concentration of home equity loans concentrated in the Midwest.

Mid-Cap Banks Equity Research

Steven Alexopoulos, CFAAC

(1-212) 622-6041

[email protected]

Stock prices are as of the close, 17July07 Equity Recommendations PrivateBancorp (PVTB—$28.20) O/W Synovus Financial (SNV—$30.95) O/W TCF Financial (TCB—$27.76) U/W Zions (ZION—$78.80) O/W

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US Small-Cap Banks Do the banks you follow originate subprime mortgages? The small cap banks in our coverage universe do not originate or purchase subprime mortgages. Accordingly, we do not anticipate an adverse earnings impact from recent erosion in subprime lending.

However, one of the 27 banks in our small cap coverage universe, BankUnited, specializes in “nontraditional” mortgages. Option ARMs make up nearly 60% of BankUnited’s loans. While these loans are not subprime (based on the borrowers’ credit scores), option ARMs have come under increased scrutiny as they allow borrowers to pay less than the fully amortizing monthly payment, which can create negative amortization (allowing the balance of the mortgage to grow over time). This possibility generally makes such loans higher risk. Despite these risks, we expect credit losses at BankUnited to remain manageable through the current real estate cycle. Cumulative negative amortization at BankUnited remains modest at just 2.5% of total option ARM balances. Furthermore, while nonperforming loans will likely continue to rise sharply over the remainder of 2007, still solid collateral values in Florida (given a healthy economy, albeit with moderation in home prices) and active collection efforts should mitigate related credit losses. Importantly, we expect losses to be notably less than what is implied in the stock’s steep discount price-to-book valuation. We rate BankUnited Overweight.

What about the banks’ commercial loan businesses? Subprime problems are affecting both growth and the credit quality of construction and land development lending. Construction and land development loans make up 14% of loans on average at our small cap banks. The pullback in credit available to subprime borrowers from other institutions, and to a greater extent the broader residential downturn, has depressed demand for properties from homebuilders and developers, and has begun to impact credit quality. Weakening trends at homebuilders could be pronounced at some small-cap banks as these institutions are typically dependent on localized markets and relatively few developers.

In light of these pressures, we favor well-managed banks with solid balance sheets and conservative underwriting. While it is not immune to mounting pressures on homebuilders, we continue to recommend Cullen/Frost in this environment owing to the bank’s conservative credit culture and its well diversified footprint in growing Texas markets.

Small-Cap Banks Equity Research

John PancariAC

(1-212) 622-6564

[email protected]

Stock prices are as of the close, 17July07 Equity Recommendations BankUnited (BKUNA—$18.97) O/W Cullen/Frost (CFR—$54.23) O/W

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European Banks How are concerns about subprime affecting the big banks in Europe? It’s not subprime defaults that will affect European banks, but rather the slowdown in new issuance of asset-backed securities. Due to subprime dislocation, we expect the US ABS market to slow down notably, particularly residential mortgage-backed securities, home-equity loans, and commercial mortgage-backed securities to have much slower growth going forward. These three types of securities account for 65% of US ABS volumes and 53% of the US revenue of the European banks in our universe. With the largest revenue generator slowing, we expect materially slower growth in volumes and revenues from investment banking operations in the US. The outlook for ABS volume and revenue growth in Europe and Asia is positive, but this is not enough to offset the US ABS slowdown in the medium term.

Which European banks are most affected? In terms of profits, securitization is most important for Deutsche Bank and Credit Suisse (Table 4). As a share of investment banking revenues, RBS, Calyon, and ABN lead, but these companies are not among the overall leaders in investment banking.

Table 4: European Banks ABS earnings impact analysis, 2006 $ million

Total

volumes Revenues Pretax profits

% of group

revenues

% of group profits

Revenues % of IB

Revenues Investment Banks Deutsche Bank 197,270 2,033 1,017 5.5% 10.8% 9.2% Credit Suisse 143,453 1,569 784 5.3% 9.1% 9.3% UBS 108,921 850 425 2.0% 3.3% 4.8% France BNP Paribas 83,878 837 418 2.1% 3.0% 7.7% Société Générale 59,479 563 281 1.8% 2.7% 6.1% Calyon 81,367 812 406 3.1% 3.4% 11.1% Natixis 20,944 347 174 3.5% 4.5% 7.4% Benelux ABN 48,038 556 278 1.8% 3.6% 11.1% Fortis 17,308 137 69 1.0% 0.9% 3.7% Dexia 1,689 21 11 0.2% 0.3% 0.6% ING 4,134 56 28 0.1% 0.2% 0.7% UK Barclays 111,283 1,109 554 2.4% 3.7% 9.0% RBS 150,033 1,677 839 3.3% 4.2% 12.4% HSBC 60,385 570 285 0.4% 0.7% 2.1% Lloyds 2,816 14 7 0.1% 0.1% 0.2% Germany Commerzbank 3,288 47 23 0.4% 0.6% 2.1% Dresdner 926 18 9 0.2% 0.4% 0.4% DZBank 264 5 3 0.3% 0.4% 0.2% Spain, Italy, Other Santander 3,358 16 8 0.0% 0.1% 0.5% BBVA 1,455 20 10 0.1% 0.1% 1.7% Sampo 631 8 4 0.1% 0.3% NA Banesto 365 7 4 0.2% 0.3% NA Unicredit-HVB 9,243 57 29 0.2% 0.2% 0.1% Grand Total 3,149,207 29,146 14,573

Source: JPMorgan estimates, Credit flux. Note: revenue data based on Creditflux volumes and JPMorgan equity research margin assumptions by product segment. For ABS revenue estimates, we use a standardised approach accounting for i) a fee margin, ii) secondary trading revenues, iii) principal/carry revenues and iv) related credit derivatives cross sales. We give RBS and CSG credit for leading positions in RMBS and CMBS respectively.

European Banks Equity Research

Kian AbouhosseinAC

(44-20) 7325 1523

[email protected]

Stock prices are as of the close, 17July07 Equity Recommendations ABN Amro (AAH.AS—€37.15) N Credit Suisse (CSGN.VX—SFr89.85)

O/W

Deutsche Bank (DBKGn.DE—€108.23)

U/W

RBS (RBS.L—p636.5) O/W

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Asian Banks Are US subprime problems being felt in Asia? Asian financial institutions have been generally risk averse over the past few years and thus have limited exposure to US subprime credit risk. HSBC is an exception to this and is discussed separately.

Exposure – Thus far, some banks and insurers in Asia have disclosed exposure to US CDOs and in aggregate these remain modest, relative to earnings and balance sheet size. We should also emphasize that not all of these exposures are to US subprime lending and generally rated "A" and above.

Disclosure – has been patchy. In our view, some exposures reside in Korea, Taiwan (insurers) and possibly China (small) and Singapore (insignificant). Yet again, we would emphasize that CDO exposure should not be equated with subprime exposure.

Impact – Financially, we expect almost an insignificant direct impact on Asian institutions (see below for HSBC) given the relatively modest exposures and a focus on higher rated paper. However, impact on equity prices of any disclosure tends to be disproportionately larger as witnessed recently at some Korean banks. This is, in our view, much more of a short-term impact.

HSBC - The institution that has been most affected is HSBC. While its 1Q07 provisioning was uneventful, credit quality has deteriorated across its Household Finance US consumer-lending subsidiary (20% of group loans) as delinquencies and charge-offs have risen across all product classes. Modified loans have now risen steadily for two quarters, masking underlying deterioration in credit quality.

2Q07 earnings are likely to be similarly uneventful given that we expect a skew in 2H07 following a wave of mortgage resets (impact is expected to be amplified by the resets being an industry-wide phenomenon). A false sense of security may well prevail, but we urge investors to remain cautious on 2H credit deterioration. At this stage, we believe risks lie not just in sub-prime mortgages but also in other “non-prime” unsecured credit at HFC - auto finance, credit cards and personal loans. All these categories have shown deterioration in credit quality in recent quarters.

We have thus far remained sanguine on the non-HFC book in the US, which is generally considered “prime.” At this stage this is seen as a limited risk, with little evident contagion outside the “non-prime” businesses and reasonably robust economic conditions.

HSBC’s shares have under-performed in what have been strong equity conditions in HK/Asia, although they have not lost value in absolute terms. We expect this under-performance to continue as US earnings remain a drag.

Asian Banks Equity Research

Sunil GargAC

(852) 2800 8518

[email protected]

Stock prices are as of the close, 17July07 Equity Recommendations HSBC (0005.HK—HK$144.90) U/W

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Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

Conflict of Interest:

This research contains the views, opinions and recommendations of JPMorgan credit research analysts. Research analysts routinely consult with JPMorgan trading desk personnel in formulating views, opinions and recommendations in preparing research. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and report(s). Therefore, this research may not be independent from the proprietary interests of JPMorgan trading desks which may conflict with your interests. In addition, research analysts receive compensation based, in part, on the quality and accuracy of their analysis, client feedback, trading desk and firm revenues and competitive factors. As a general matter, JPMorgan and/or its affiliates normally make a market and trade as principal in fixed income securities discussed in research reports.

Important Disclosures

Important Disclosures for Equity Research Compendium Reports: Important disclosures, including price charts for all companies under coverage for at least one year, are available through the search function on JP Morgan’s website https://mm.jpmorgan.com/disclosures/company or by calling this U.S. toll-free number (1-800-477-0406)

Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: JPMorgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] The analyst or analyst’s team’s coverage universe is the sector and/or country shown on the cover of each publication. See below for the specific stocks in the certifying analyst(s) coverage universe.

JPMorgan Equity Research Ratings Distribution, as of June 29, 2007

Overweight (buy)

Neutral (hold)

Underweight (sell)

JPM Global Equity Research Coverage 44% 41% 16% IB clients* 50% 50% 38% JPMSI Equity Research Coverage 40% 47% 13% IB clients* 69% 62% 48%

*Percentage of investment banking clients in each rating category. For purposes only of NASD/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.

Equity Valuation and Risks: Please see the most recent company-specific research report for an analysis of valuation methodology and risks on any securities recommended herein. Research is available at http://www.morganmarkets.com , or you can contact the analyst named on the front of this note or your JPMorgan representative.

Explanation of Credit Research Ratings: Ratings System: JPMorgan uses the following sector/issuer portfolio weightings: Overweight (over the next three months, the recommended risk position is expected to outperform the relevant index, sector, or benchmark), Neutral (over the next three months, the recommended risk position is expected to perform in line with the relevant index, sector, or benchmark), and Underweight (over the next three months, the recommended risk position is expected to underperform the relevant index, sector, or benchmark). JPMorgan’s Emerging Market research uses a rating of Marketweight, which is equivalent to a Neutral rating.

Valuation & Methodology: In JPMorgan’s credit research, we assign a rating to each issuer (Overweight, Underweight or Neutral) based on our credit view of the issuer and the relative value of its securities, taking into account the ratings assigned to the issuer by credit rating agencies and the market prices for the issuer’s securities. Our credit view of an issuer is based upon our opinion as to whether the

https://mm.jpmorgan.com/disclosures/company

http://www.morganmarkets.com/

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issuer will be able service its debt obligations when they become due and payable. We assess this by analyzing, among other things, the issuer’s credit position using standard credit ratios such as cash flow to debt and fixed charge coverage (including and excluding capital investment). We also analyze the issuer’s ability to generate cash flow by reviewing standard operational measures for comparable companies in the sector, such as revenue and earnings growth rates, margins, and the composition of the issuer’s balance sheet relative to the operational leverage in its business.

Analysts’ Compensation: The research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities, Fixed Income, and Investment Banking.

Other Disclosures

Options related research: If the information contained herein regards options related research, such information is available only to persons who have received the proper option risk disclosure documents. For a copy of the Option Clearing Corporation’s Characteristics and Risks of Standardized Options, please contact your JPMorgan Representative or visit the OCC’s website at http://www.optionsclearing.com/publications/risks/riskstoc.pdf.

Legal Entities Disclosures U.S.: JPMSI is a member of NYSE, NASD and SIPC. J.P. Morgan Futures Inc. is a member of the NFA. JPMorgan Chase Bank, N.A. is a member of FDIC and is authorized and regulated in the UK by the Financial Services Authority. U.K.: J.P. Morgan Securities Ltd. (JPMSL) is a member of the London Stock Exchange and is authorised and regulated by the Financial Services Authority. Registered in England & Wales No. 2711006. Registered Office 125 London Wall, London EC2Y 5AJ. South Africa: J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. Hong Kong: J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission in Hong Kong. Korea: J.P. Morgan Securities (Far East) Ltd, Seoul branch, is regulated by the Korea Financial Supervisory Service. Australia: J.P. Morgan Australia Limited (ABN 52 002 888 011/AFS Licence No: 238188) is regulated by ASIC and J.P. Morgan Securities Australia Limited (ABN 61 003 245 234/AFS Licence No: 238066) is a Market Participant with the ASX and regulated by ASIC. Taiwan: J.P.Morgan Securities (Taiwan) Limited is a participant of the Taiwan Stock Exchange (company-type) and regulated by the Taiwan Securities and Futures Commission. India: J.P. Morgan India Private Limited is a member of the National Stock Exchange of India Limited and The Stock Exchange, Mumbai and is regulated by the Securities and Exchange Board of India. Thailand: JPMorgan Securities (Thailand) Limited is a member of the Stock Exchange of Thailand and is regulated by the Ministry of Finance and the Securities and Exchange Commission. Indonesia: PT J.P. Morgan Securities Indonesia is a member of the Jakarta Stock Exchange and Surabaya Stock Exchange and is regulated by the BAPEPAM. Philippines: J.P. Morgan Securities Philippines Inc. is a member of the Philippine Stock Exchange and is regulated by the Securities and Exchange Commission. Brazil: Banco J.P. Morgan S.A. is regulated by the Comissao de Valores Mobiliarios (CVM) and by the Central Bank of Brazil. Japan: This material is distributed in Japan by JPMorgan Securities Japan Co., Ltd., which is regulated by the Japan Financial Services Agency (FSA). Singapore: This material is issued and distributed in Singapore by J.P. Morgan Securities Singapore Private Limited (JPMSS) [mica (p) 069/09/2006 and Co. Reg. No.: 199405335R] which is a member of the Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore (MAS) and/or JPMorgan Chase Bank, N.A., Singapore branch (JPMCB Singapore) which is regulated by the MAS. Malaysia: This material is issued and distributed in Malaysia by JPMorgan Securities (Malaysia) Sdn Bhd (18146-x) which is a Participating Organization of Bursa Malaysia Securities Bhd and is licensed as a dealer by the Securities Commission in Malaysia. Pakistan: J. P. Morgan Pakistan Broking (Pvt.) Ltd is a member of the Karachi Stock Exchange and regulated by the Securities and Exchange Commission of Pakistan.

Country and Region Specific Disclosures U.K. and European Economic Area (EEA): Issued and approved for distribution in the U.K. and the EEA by JPMSL. Investment research issued by JPMSL has been prepared in accordance with JPMSL’s Policies for Managing Conflicts of Interest in Connection with Investment Research which can be found at http://www.jpmorgan.com/pdfdoc/research/ConflictManagementPolicy.pdf. This report has been issued in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 (all such persons being referred to as "relevant persons"). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other EEA countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction Germany: This material is distributed in Germany by J.P. Morgan Securities Ltd. Frankfurt Branch and JPMorgan Chase Bank, N.A., Frankfurt Branch who are regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. Australia: This material is issued and distributed by JPMSAL in Australia to “wholesale clients” only. JPMSAL does not issue or distribute this material to “retail clients.” The recipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms “wholesale client” and “retail client” have the meanings given to them in section 761G of the Corporations Act 2001. Hong Kong: The 1% ownership disclosure as of the previous month end satisfies the requirements under Paragraph 16.5(a) of the Hong Kong Code of Conduct for persons licensed by or registered with the Securities and Futures Commission. (For research published within the first ten days of the month, the disclosure may be based on the month end data from two months’ prior.) J.P. Morgan Broking (Hong Kong) Limited is the liquidity provider for derivative warrants issued by J.P. Morgan International Derivatives Ltd and listed on The Stock Exchange of Hong Kong Limited. An updated list can be found on HKEx website: http://www.hkex.com.hk/prod/dw/Lp.htm. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul branch. Singapore: JPMSI and/or its affiliates may have a holding in any of the securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Legal Disclosures section above. India: For private circulation only not for sale. Pakistan: For private circulation only not

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for sale. New Zealand: This material is issued and distributed by JPMSAL in New Zealand only to persons whose principal business is the investment of money or who, in the course of and for the purposes of their business, habitually invest money. JPMSAL does not issue or distribute this material to members of "the public" as determined in accordance with section 3 of the Securities Act 1978. The recipient of this material must not distribute it to any third party or outside New Zealand without the prior written consent of JPMSAL.

General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively JPMorgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMSI and/or its affiliates and the analyst’s involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMSI distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a JPMorgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.

Revised June 25, 2007.

Copyright 2007 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of JPMorgan.

jpmorgan q&a · with spreads as wide as the 105 area. lbo activity could decrease modestly...

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