mcleish unwinding the tape

8/14/2019 Mcleish Unwinding the Tape

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Deleveraging: Unwinding the Tape

November 5, 2008

Primary Analysts: Neil McLeish +44 20 [email protected] Sheets +44 20 7677-2905

Phanikiran Naraparaju +44 20 7677-5065Ahmed Nassar +44 20 7677-0257

Morgan Stanley & Co. International plc

The Primary Analyst(s) identified above certify that the views expressed in this report accurately reflect his/her/their personal views about the subjectsecurities/instruments/issuers, and no part of his/her/their compensation was, is or will be directly or indirectly related to the specific views orrecommendations contained herein.

This report has been prepared in accordance with our conflict management policy. The policy describes our organizational and administrativearrangements for the avoidance, management and disclosure of conflicts of interest. The policy is available at www.morganstanley.com/institutional/research.

Please see additional important disclosures at the end of this report.


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2

Breaking Down Deleveraging

We see deleveraging as an issue that has, and will, unfold in stages.1) The first stage was dominated by product deleveraging in SIVs, ABS CDOs, CPDOs, etc. These

products contained financial leverage and structural leverage in varying degrees, but a strong themewas the underperformance of higher-quality risks. Main underperformed XOver, super-seniorunderperformed equity, credit underperformed stocks

2) The second stage was deleveraging by banks, and our analysis of bank balance sheets indicatesthat steady progress has been made in reducing asset exposures. Recent capital injections bygovernments have dramatically accelerated this process. We remain very bullish on bank debt, andwe view it as a shrinkingasset class in the context of further deleveraging

3) The third stage (which we think we have been in) seems more focused on investor deleveraging, asvolatile markets, leveraged positions and tighter credit have all added significant pressure

4) The last stage, in our view, will be deleveraging by (mostly US and UK) consumers. By its nature,this will take longer to play out, and we see its effect playing out over the course of several years


Over the last several weeks, a dominant theme in client conversations has been deleveraging. How bigis the problem? How much further will it go? What, if anything, will break the negative feedback loop?

While deleveraging has been an oft-proscribed ailment of markets, the difficulty of quantifying theproblem has made it that much more intimidating as a market force. In this note, we attempt to push

back some on the deleveraging theme. This is not the first stage of deleveraging in this credit cycle, andis unlikely to be the last. But in our view, not enough credit is being given for progress in the marketslargest, most leveraged sector: Banks


3/16

3

Non-Bank Deleveraging Underway for Some Time

The hardest aspect of deleveraging is separating those who are being forced to sell from the selling thatoccurs because of good old-fashioned concern. SIVs and ABS CDOs were both massive players incorporate and ABS credit markets, respectively. Note the risk reductions here have been going on, almostcontinuously, since autumn 2007. But a major adjustment to financial CP post the Lehman default has,somewhat violently, brought the CP market back to its 2001 levels

Asset Backed + Financial CP at 2001 Levels CDO Liquidations Since December 2007

Source: Morgan Stanley Research, Federal ReserveNote: Predominately ABS CDOs

Source: Morgan Stanley ResearchPlease see additional important disclosures at the end of this report.

$Bn Outstanding

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2001 2002 2003 2004 2005 2006 2007 2008

Asset-Backed CP

Financial CP

Combined

Cumulative Liquidations ($mm)

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

Dec-07

Jan-08

Feb-08

Mar-08

Apr-08

May-08

Jun-08

Jul-08

Aug-08

Sep-08

Oct-08


4/16

4

Banks Are Making Significant Progress

The capital injections over the last several weeks are substantial, and there is tangible evidence ofdeleveraging (raising equity or selling assets both do the trick). Tier 1 ratios for major US and Europeanbanks are now substantially higher than a year ago, despite the deluge of write-downs and provisioning.Banks are certainly shedding assets too but, importantly, this has been a steady process, in our view, nota recent phenomenon. Particularly important to our world, over US$121 billion of corporate bonds havebeen sold off from the balance sheets of the Primary Dealers over the last year

Tier 1 Ratios Post-Injections & Capital Raises Far Fewer Corporate Bonds on Dealer Balance Sheets

Source: Morgan Stanley ResearchNote: Corporates >1yr in maturitySource: New York Federal Reserve


Tier 1 Ratio

6%

7%

8%

9%

10%

11%

12%

13%

14%

3Q07 4Q07 1Q08 2Q08 3Q08 3Q Pro

Forma

CS

RBS

BARC

DBCJPM

SocGen

BACBNP

$Bn Corporate Bonds held by Primary Dealers

$0

$50

$100

$150

$200

$250

Jul-01

Jul-02

Jul-03

Jul-04

Jul-05

Jul-06

Jul-07

Jul-08


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5

$Bn Outstanding Leveraged Finance Exposures

$0

$50

$100

$150

$200

$250

$300

$350

3Q07 4Q07 1Q08 2Q08 3Q08

GS

LEH

MER

JPM

Citi

BACUBS

BARC

RBS

DB

CS

BNP

Focusing on Bank Exposure to Leveraged Finance

To focus on bank risk reduction in more detail, we turn to the leveraged finance sector. Net exposuresamong large underwriters have fallen 68% YoY, through a combinations of write-downs, sales andterminations. Again, progress here has been measured and steady over several quarters, which isimportant given the size of the exposure that needed to be worked through

Major Reductions in Leveraged Finance Risk Risk Reduction Through Lower Marks

Source: Morgan Stanley Research,Company Reports


- 68%

Avg. Mark on Leveraged Finance (% of Par)

BNP

CS

BAC

Citi

JPM

MER

DB

RBS

LEH

GS

60%

65%

70%

75%

80%

85%

90%

95%

100%

4Q07 1Q08 2Q08 3Q08


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Cumulative Delta-Neutral Return

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

Dec-07 Mar-08 Jun-08 Sep-08

CDX 30-100% iTraxx 22-100%

High Quality Responding Differently to Deleveraging

A major theme of the deleveraging from earlier this year was the underperformance of higher-qualityassets, as investors looked to shed negative convexity, and banks looked to hedge notional risk (which iseasier to do up the capital structure. Super-senior tranches underperformed equity, LVol underperformedHVol, and AAA ABX and CMBX were hammered. This is not the case today. Credit is only back to Marchwides while equities made large new lows. Super-senior tranches have been stellar, and cyclicals (Hvol)were hit hard. So, something is certainly different about the most recent deleveraging wave

Super-Senior Performance Is Telling HVol vs. LVol: Different Deleveraging Response

Source: Morgan Stanley ResearchSource: Morgan Stanley Research, Bloomberg


Super-Senior Outperforming,despite deleveraging

Super-Senior suffers,deleveraging blamed

0

50

100

150

200

250

300

350

400

0 25 50 75 100 125 150LVol

HVol

Today

March 13


7/16

7

Tighter Credit, Fewer Loans

Credit rationing ahead of a deteriorating economic backdrop (rather than deleveraging in the strict sense)better explains the high-quality/low-quality price action in recent moves. A new SLOS from the Fed out onNovember 3 indicates that C&I credit conditions continue to contract, and loan growth looks to slowconsiderably further

European Lending Standards Still Net TighterC&I Lending Continues to Tighten in US

Source: Federal Reserve Senior Loan Officers Survey, 3 Nov 08Source: Morgan Stanley Research, ECB


Net % of Institutions Reporting Tightening

-40

-20

0

20

40

60

80

100

Jun-

90

Jun-

92

Jun-

94

Jun-

96

Jun-

98

Jun-

00

Jun-

02

Jun-

04

Jun-

06

Jun-

08

Mortgage

C&I

Prime Mortages

Subprime Mortgages

Net % Tightening of Credit Standards To

Euro Area Residents

-20

-10

0

10

20

30

40

50

60

70

Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008

Total

HousingNon-Fin. Corporates

Consumer Lending


8/16

8

While Deposit Growth Is Now Outstripping Asset Growth

Simultaneous to tighter lending standards, banks are pushing aggressively for deposit funding. One canhardly blame them, given the current gap between unsecured senior yields and term deposits, and equitymarkets being increasingly punitive to wholesale funding. For the first time since 2002, YoY growth indeposits exceeds YoY growth in assets for US, European and UK banks. Less spending by consumersand a broader investor move into cash over the last two months also help

Deposit Growth Now Greater than Asset Growth and Deposit Funding Looks Very Attractive

Source: Morgan Stanley Research, ECB, BoE, Federal ReserveSource: Morgan Stanley Research, BoE, iBoxx


YoY Asset Growth - YoY Deposit Growth

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

2000 2001 2002 2003 2004 2005 2006 2007 2008

US

Europe

UK3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

1996 1997 1999 2000 2002 2003 2005 2006 2008

UK Fixed Rate Bond Deposit rate

Yield on AA-Rated Bank Paper


9/16

9

Meaning That Bank Debt Is a ShrinkingAsset Class

Lending continues to tighten, deposits are growing faster than new loans, and government-supportedfunding avenues are being made available to banks. With all this, the attractiveness of unsecured fundingvia capital markets at current prices is certainly reduced, helping to push net issuance in bank debtnegative for the first time since our data began. Even if we repeat 2004-05 issuance trends, a heavyredemption profile will mean bond supply continues to contract. This is a technical positive for bank debt

Net Issuance Now Negative, and Barring a Major Capital Markets Reversal, Will Stay That Way

Source: Morgan Stanley Research, Dealogic Please see additional important disclosures at the end of this report.

12m Net Issuance / Nominal GDP

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Financial Net Issuance

Assuming 2004 Issuance Going Foward

Bond Supply Shrinking


10/16

10

Hedge Funds and Deleveraging

Can we quantify pressure to de-lever at hedge funds? Through September 2008, net outflows were fairlysmall in relation to overall assets, but we acknowledge the prisoners dilemma at work here, as manyinvestors must prepare for outflows that only some will eventually experience

Net Asset Flow from Credit Hedge Funds but Credit Hedge Fund Assets Are Still WellAbove 2006 Levels

Source: Hedge Fund Research, Morgan Stanley ResearchSource: Hedge Fund Research, Morgan Stanley Research


Net Asset Flow $Bn

-10

-5

0

5

10

15

20

25

30

35

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008YTD

FI: Corporate

FI: Asset Backed

Credit ArbitrageDistressed

Credit HF Assets $Bn

0

50

100

150

200

250

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008Q1

2008Q2

2008Q3

FI: Corporate

FI: Asset Backed

Credit Arbitrage

Distressed


11/16

11

The Scope for Further European Loan Sales?

Further deleveraging in European secured loans will be a story of the various holders. CDOmanagers (ie, CLOs) will be strong hands, in our view, as only ~5% of these vehicles have MtMtriggers (the rest enjoy term funding of liabilities at attractive terms). CLOs are restricted frombuying large parts of the loan market because prices are too low, as CLO mandates generallyrequire a minimum price of $80 on purchases of new loan collateral.

In the table below, we attempt to estimate the holder base of leveraged loans from disclosures ofnew issue purchases, adjusted for repayment profiles and vintage balance of the current market.While imperfect, we think it helps to put the size of the various holders in context

Estimates of Holdings of European Leveraged Loans

Note: Data suggest that nearly all 2003-vintage and earlier loans have been refinancedSource: Morgan Stanley Research, S&P LCD


Vintage

Non-European

Banks

European

Banks

Securities

Firms

Finance

Co. Insurance

CDO

Managers

Credit

Funds

Prime Rate Rate /High Yield Retail

Funds Total

2004 1.0 5.8 0.5 0.1 0.1 2.1 0.2 0.0 9.8

2005 4.3 21.7 1.8 1.0 0.4 13.2 4.1 0.0 46.6

2006 8.0 35.9 4.2 1.1 0.3 36.3 8.2 0.6 94.5

2007 12.3 46.6 11.3 2.0 1.0 56.2 22.5 5.2 157.0

2008 5.3 29.1 1.5 0.3 0.6 8.6 5.5 0.5 51.3

Total 30.9 139.1 19.2 4.5 2.4 116.3 40.5 6.2 359.2


12/16

12

Navigating the Stages of Deleveraging

Deleveraging has been a dominate market theme over the last several weeks, but it is hardly a new one.We have gone through several stages of deleveraging since the crisis started, this is only the most recent

We believe that the deleveraging of the banking system (and large swathes of leveraged vehicles) hasprogressed much further than investors give credit for. Based on client conversations, it is here where we

differ most from the consensus. The major banks in Europe and the US have raised significant amounts ofTier 1 capital, and aggressively marked down large quantities of credit assets. Overall, we believe thatsignificant bank deleveraging has already occurred

Technicals for bank paper are also positive, in our view. Banks are tightening credit, and appear to betaking in deposits faster than new loans are being granted. At the same time, large new providers of bankfunding have sprung up in the form of bank-guaranteed paper (where investors are indexed to a

Super/Sovereign benchmark), and central governments themselves. All these help to explain whyunsecured bank debt is now a shrinking asset class, and could remain one over the next 18 months.

Investor deleveraging remains a risk in higher-beta, less liquid parts of the market where it will take timefor new investors to step into the market (e.g., leveraged loans).

The last stage will be deleveraging of the consumer, which is just starting and will drive a severe hit to

cyclical earnings in 2009. Bank paper remains our preferred sector, but we would still be looking to golong non-cyclicals that have been beaten down by recent investor deleveraging (German Cable Loans,Telecom, Utilities, IG Pharma) against more cyclical credits. We are aggressive buyers of IG new issues,believing they select for credits which have market access, are cheap, and allow investors with drypowder to invest alongside those in a similarly strong position



13/16

13

Rating Distribution Table


Credit Products Rating Distribution Table

(as of Oct 31, 2008)

Rating Count

% of

Total Count

% of

Total IBC

% of

Rating Category

Overweight 82 36% 49 33% 60%

Equal-weight 89 39% 61 41% 69%

Underweight 56 25% 37 25% 66%

Total 227 147

Analyst Ratings Definitions

Equal-weight (E) Over the next 6 months, the fixed income instruments total return is expected to be in line with the average total

return of the relevant benchmark, as described in this report, on a risk adjusted basis.

Underweight (U) Over the next 6 months, the fixed income instruments total return is expected to be below the average total

return of the relevant benchmark, as described in this report, on a risk adjusted basis.

More volatile (V) The analyst anticipates that this fixed income instrument is likely to experience significant price or spread

volatility in the short term.

Coverage Universe Investment Banking Clients (IBC)

Coverage includes all compani es that we currently rate. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received

inv estment banking compensation in the last 12 months.

Overweight (O) Over the next 6 months, the fixed income instruments total return is expected to exceed the average total return

of the relevant benchmark, as described in t his report, on a risk adjusted basis.


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Disclaimer

Important Disclosures On Subject Companies

The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated and/or one or more of its affiliates (collectively, Morgan Stanley) and the

research analyst(s) named on page one of this report.

Morgan Stanley policy prohibits research analysts from investing in securities/instruments in their MSCI sub industry. Analysts may nevertheless own such

securities/instruments to the extent acquired under a prior policy or in a merger, fund distribution or other involuntary acquisition.

Morgan Stanley is involved in many businesses that may relate to companies or instruments mentioned in this report. These businesses include market making, providingliquidity and specialized trading, risk arbitrage and other proprietary trading, fund management, investment services and investment banking. Morgan Stanley trades as

principal in the securities/instruments (or related derivatives) that are the subject of this report. Morgan Stanley may have a position in the debt of the Company or

instruments discussed in this report.


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