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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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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
Please see additional important disclosures at the end of this report.
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
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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
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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
Please see additional important disclosures at the end of this report.
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
$250
Jul-01
Jul-02
Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
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$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
Please see additional important disclosures at the end of this report.
- 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
Please see additional important disclosures at the end of this report.
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
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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
Please see additional important disclosures at the end of this report.
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
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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
Please see additional important disclosures at the end of this report.
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
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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
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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
Please see additional important disclosures at the end of this report.
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
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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
Please see additional important disclosures at the end of this report.
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
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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
Please see additional important disclosures at the end of this report.
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Rating Distribution Table
Please see additional important disclosures at the end of this report.
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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