Credit Outlook - Stanford University

ILEHMi\N BROTHERS!

Credit Outlook

April2008

Eric Felder

This material has been prepared by Credit Trading and is not a product of Lehman's Research Department. It is for information purposes only. All levels and prices are indications only and do not represent firm market levels. Changes in market conditions since the issuance of this document may affect some or all of the levels and prices listed. For firm levels and prices please call the desk. Lehman Brothers Inc. and/or its affiliates may trade and/or have a principal position in the securities, financial instruments and/or related derivatives mentioned herein.

FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC.

LBH I_ SEC07940 _ 393578

After a Period of Low Volatility, 2007 was a Turning Point in the Credit Cycle. In 2008, Credit has had its Worst Start to a Year on Record.

(bp)

900

600

300

0

(300) .

(600)

·····lillliilllil·····

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1110 2008

Source: Lehman Brothers.

LEHMAN BRC)THERS


1

LBH I_ SEC07940 _ 393579

As a Loss of Faith in Rating Agency Models Impaired the Securitization Process ...

Liabilities

$

IRatingAgency] // ./ $

Liabilities ... /··/

····· .... $

Liabilities

$

Liabilities IRatingAgencyJ • $ Liabilities ·

LEHMAN BRC)THERS


2

$ ,···

LBH I_ SEC07940 _ 393580

And pushed "Risk-Free" Asset Spreads to All-Time Wides, Which, in Turn, Made Credit Appear Very Rich on a Relative Basis

900 .····

800 .

700 .

600 .

500 .......................................................... .

400 .·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.0·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.~

300 .......................................................... .

200 .

100 .·.·.·.·.·.·.·.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· .. ·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·. #

O""""·"""""""'"""""""'"""""""'"""""""'"""""""'"""""""'""""""""""""""'"""""""'""""""""""""""'~ Jan-06 Jul-06 Jan-07 Jul-07 Jan-08

350 .····

3oo ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·. m

250 .

200 .

150 .......................................................... .

100 .......................................................... .

50 .

0 .

Jan-06 Jul-06


Jan-07 Jul-07 Jan-08

Sp; eud w LIBOfl shu rm, Em opeun F6'rfBS Sp; eud inaVcazes Dutch :A:47I Sp; eua':s 5 y; Fixed w Srvap.

LEHMAN BRC)THERS 3

200 .····

175 .

150 .

125 .

100 .

75 .····

50 .

25 .

0 .

Jan-06

200 .····

180 .

160

140 .

120 .

100 .····

80 .

60 .

Jul-06 Jan-07 Jul-07

40 ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· .. ·.·.··.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·F

20 -.----------------------~ Jan-06 Jul-06 Jan-07 Jul-07

Jan-08

Jan-08

0


LBHI_SEC07940_393581

And Locked the Market into a Vicious Cycle Where Delevering in One Asset Class Caused De levering in Another

0

800 ......................................................................... . ABX 06-2 AAA Implied Spread

700 ·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.··.·.·.·.·.·.~·.··.·.·.·.·.·.· .. ·.·.·.·.·~.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·./·.1%········

600 ....................................................... .

500 .·····

400

300

200

100 . 0 llllllllllllllllllllll~ .... ;t!t ........ :::?.% .... ~

300

250 ....................................................... .

200 ....................................................... .

150

100 ....................................................... .

50 ....................................................... .

0 .. ,.,.,.,,,,,.,·,:,.,.,.,.,.,.,.,.,,:·,·,·,·,·,·,·,·,·,·:·:·,·,·,·,·,·,·,·:·:·:·:·:·:·:·:.:.;.;.;.;.;.;.,.,.,.,.,.,.;.;.;.;.;.;.;.:::·:

80 .

60

40

0

-20

01107


04/07 08/07

LEHMAN BRC)THERS

12/07


03/08

4

iiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiili~llliliiiBIBBiiiiBBIII,~iiii~BB1iiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiii 120

110 ········································································································································~············

100 .

30

01107 04/07 08/07 12/07 03/08

LBH I_ SEC07940 _ 393582

Culminating in a Series of Regulatory Actions by the Fed.

250

0 .·····

07/04


08/23

LEHMAN BRC)THERS

10/12


12/01 01120

5

0

03/10

LBH I_ SEC07940 _ 393583

Which Have Materially Reduced the Likelihood of a Liquidity Event in the Financial Markets

+ Discount window will now be extended to include primary dealers (20 large, non-bank broker I dealers)

+ There is no limit on the amount of money that can be borrowed

+ The Fed will accept a wide range of investment grade collateral- including, but not limited to ABS, CP, convertible bonds, munis, and private label CMOs

+ For difficult to finance products, the haircuts are quite generous compared to current market margin levels

+ The rate charged will be 25 bp over Fed Funds

+ The new program is for overnight funding- but it is assumed to be renewable daily using the same collateral

+ Should help prevent forced liquidations


LEHMAN BRC)THERS


6

LBH I_ SEC07940 _ 393584

With a Meaningful Reduction in the Likelihood of a Tail Event, Markets have Stabilized and Sentiment has Improved Significantly

35 .

30

25

20 .

15 .

10 .·····

Jan-08 Jan-08 Feb-08 Mar-08


LEHMAN BRC)THERS


Apr-08

7

1.00 .

0.90 .·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·. ·.·.·.·.·.~·~.~.~:~.9.Y.~.~·g·.·.·.·.·.·····

0.80 .····· .·.·.·.·.·.·.·.~··

0.70 J II ·.·.·.·.·.·.·.·.·.·.·.·.·.· .. ·.·.· .. ·.·.·.·.·.· ... · .. ·.·.·.·.·.·.·~· .·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· .. ·.·.·.·.·., .. ·.·.·.·.·.·.·.·.·.·.·.·.··n···~ .·.·.·.·.·.·.· .. ·.·,

0.60 ~ .lll! l ~ +··.·.·.·.·.·.·.·.~~%~~! Iii Iii···· ····· ~~···~··.·.·.·.·. 1··.·.·.·.·.·.·.·.~ ~nl. ········· n.·.·.·.·.·.·.·l······

0.50

0.40 ~~················· ................. ~A·· 0.30 =r=~===r~r·········· , ........................... ,.:

Risk-Averse

Jan-07 Apr-07 Aug-07 Dec-07 Apr-08

LBH I_ SEC07940 _ 393585

However, Questions Regarding the Fundamental Outlook and Potential Ongoing Stress From the High Leverage Levels Left in the System Remain

Along these lines, we see several key drivers for credit going forward

LEHMAN BRC)THERS


-

9

LBH I_ SEC07940 _ 393587

Recently, There Have Been Signs of Liquidity Normalization as Firms Have Been Able to Raise Capital in Segments of the Market That Appeared Shut Just One Month Ago ...

12,000

10,600

10,000 .

8,000 .

2,000

0 = .c ""' ""'

>. Q) >. ell c. - > '-' ~ Q) ~ c. ~ = = = Q) '-' 0 Q)

>-:> ... ~ < ~ = < rFl 0 z ~ >-:> >-:>


LEHMAN BRC)THERS


= .c ""' ""' ~ Q) ~ c. >-:> ... ~ <

~ E-< ~

10

Deal Size, $bn

8

6

4

0

FNMA,

Dec-07 ~ C,Jan-08 BACR, WB, HSBC,

Nov-07 Apr-08 Dec-07 Apr-08

LBH I_ SEC07940 _ 393588

And There Has Been Renewed Demand for Leveraged Loans (Particularly from Private Equity)

250

200 BIIIIBIIII!jiiiilll!jiii!iillljiiiBIIIIBIIII~UIIIjiii!illll

150 .

100

50 .

0 .

6/27/07


9/26/07

LEHMAN BRC)THERS

119/08


4/9/08

11

LIBOR 2.70% Loan Coupon 2.75%

Loan Price 88 Leverage 3 Funding Cost 1.25%

Cash On Cash Yield 12.92%

IRR Assuming Principal Repayment at End of Period End of 3 Years 29.01% End of 4 Year End of 5 Years End of 6 Year End of 7 Years

24.23% 21.50% 19.74% 18.52%

LBH I_ SEC07940 _ 393589

There Have Also Been Signs of Stability in the Muni Market, Where Record Yields (When Compared to Other Assets) Have Helped Expand The Buyer Base

80 .

79 .

72·

71 ·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·

70 .

11101


12/03

LEHMAN BRC)THERS


01104 02/06 03/09 04/11

12

LBH I_ SEC07940 _ 393590

Certain Segments of the Mortgage Space Have Shown Signs of Stabilization

0 ----........_ ___ _

5

10 .

15

20 .

25 Dec-06 Apr-07


Aug-07

LEHMAN BRC)THERS

Dec-07


Apr-08

13

Spread(bp)

80

70

60

50

40

30

10

0

Jan-01 Jan-26 Feb-20 Mar-16 Apr-11

LBHI_SEC07940_393591

While There Have Been Many Positive Developments on the Liquidity Front in Recent Weeks, Renewed Signs of Stress in the Funding Markets Indicate That Normalization Is Unlikely to Be an Overnight Process

Change From (bp)

10-April 15-Mar 15-Dec Jun-07

Rates

2y Tsy

lOy Tsy

2y2y BE

SySy BE

Spreads!Vol

2y Sprd

lOy Sprd

MtgLOAS

CDXHG

CDXHY

3m2y Vol

Money Market

3mLIBOR-FF

6m6m LIBOR-FF

FF GC (lm)

1.86

3.53

2.03

2.45

81

65

40

117

617

135

76

42

15

Source: Lehman Brothers Interest Rates Strategy.

LEHMAN BRC)THERS

28 -119

-1 -51

-40 -16

-23 5

-17 -16

-14 -5

-26 33

-61 41

-135 131

-27 5

3 -26

0 7

-27 -32


-311

-157

-39

0

35

4

46

80

328

69

64

30

1

14

120 .................................................................................................................................................. 50

100

80

20

0

6/112007 8/18/2007

-Bank CD- OIS (1m)

6m6m LIBOR-FF (RHS)

1114/2007 112112008

10

4/9/2008

····················Financial CP- OIS (1m)

LBH I_ SEC07940 _ 393592

And the Economic Backdrop has Deteriorated. The Consumer is Facing Massive Headwinds as the Housing Crisis, Tightening Lending Standards, and High Commodity Prices Take Their Toll

Factor

Unemployment Rate

Payroll Growth (6-Month MA)

Gas Prices

Lending Standards

Housing Wealth Effect

Trailing 12-Month S&P 500 Return

Savings Account Yield

30-Year Jumbo Mortgage Rate

Factor

Consumer Confidence

Automobile Sales (SAAR)

Holiday Retail Sales (Yo Y)

Credit Card Delinquency Rate

Auto Loan Delinquency Rate

Prime Mortgage Delinquency Rate

Subprime Mortgage Delinquency Rate

Source: Bloomberg.

LEHMAN BRC)THERS


January 2007

4.6

189K

$2.30

Loosening

1.1%

15%

4.08%

6.07%

December 2006

110.0

16.6

5.9

3.92

1.27

2.57

13.33

15

Current Impact

5.1 Negative

2K Negative

$3.39 Negative

Tightening Negative

(0.3%) Negative

-7.56% Negative

2.57% Negative

7.02% Negative

Current Impact

64.5 Negative

15.3 Negative

4.2 Negative

4.55 Negative

2.67 Negative

3.24 Negative

17.31 Negative

LBH I_ SEC07940 _ 393593

And we can Expect More Pressure to Come as Home Prices Continue to Deteriorate ...

20

Forecast

15 .............................................................. .... \:

10

5

0

-5

-10

-15

-20 Mar-88 Aug-93 Jan-99 Jun-04

Source: Federal Reserve Flow of Funds, Commerce Dept, Lehman Brothers;

Dec-09

2

1

0

-1

-2

Mar-90 Aug-94

-Housing

Jan-99 Jun-03 Dec-07

Note: Housing wealth effect assumes consumers spend 6¢ for every additional dollar of housing wealth over a two year adjustment period. Stock market wealth effect assumes consumer spend 6¢ for every additional dollar of equity wealth over a three year adjustment period (assuming a 10% increase in equities from now through year-end and 10% average increase next year.

LEHMAN BRC)THERS


16

LBH I_ SEC07940 _ 393594

Lending Standards Continue to Tighten for Consumers and Corporates

Fed Senior Loan Officer Survey: Net% of banks reporting tightening of standards

iiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiillillliiilililiiiillllliiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiii 60 ·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· , .... ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.

40 II, (::) •••••••.• Ilt __ ,.IIJH'l'll'l.'llilf'l •• IIIII ••••• ~ •••• lll!lii .•• liiiiiiiiii. (40) .·.·····

Q290 Q292 Q294 Q296 Q298 Q200 Q202 Q204 Q206

56 ·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· I

42 ·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· L

(28) .

Q390 Q392 Q394 Q396 Q398 Q300 Q302 Q304 Q306

Source: Federal Reserve.

LEHMAN BRC)THERS


17

ililililililililililililililililililililililililililililililililililililililililililililililililililllllllil~lililll~lilillllllililililililililililililililililililililililililililililililililililililililililililililililililili 100

80 ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.· .. ·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·. J

60

:: • Ut •••.....• 1 ••..•• il •..• ,... ~~~tlllllllrllfi ·~~ ,]tl 9~ . ·······················································~··················· (40) .·.·····

Q390 Q392 Q394 Q396 Q398 Q300 Q302 Q304 Q306

36

27

18

9

0

(18) ..

Q196 Q198 Q100 Q102 Q104 Q106 Q1m

LBH I_ SEC07940 _ 393595

And Corporates are Pulling Back on Investments ...

15

10

5

0

-5

Mar-05 Dec-05 Sep-06

Source: Federal Reserve Flow of Funds, Commerce Dept, Lehman Brothers,'

LEHMAN BRC)THERS


Jun-07

111111111111111% q-o-qar

18

Forecast

\

Mar-08 Dec-08 Sep-09

LBH I_ SEC07940 _ 393596

On the Back of All of These Issues, Growth is Expected to Slow. Importantly, we Believe this Will be a Global Slowdown ...

. . . And the macro backdrop will remain increasingly challenging for credit

+ We expect an extended period of slower growth as housing hits the US consumer and credit dislocation crimps activity. Aggressive fiscal and monetary easing- with a 1% terminal funds rate- should prevent a deep recessiOn

+ Despite strong fundamentals in EM, the world will not be able to "decouple": we expect a slowdown across the board

3.5%

2.8%

2.1%

1.4%

0.7%

0.0%

Global

Source: Lehman Brothers Economics. Note: 2007 Includes 4Q07 Estimate.

LEHMAN BRC)THERS

us 1111112007


EuroArea UK Japan

:::::2008 :;:::2009

19

LBH I_ SEC07940 _ 393597

Challenging Macro Backdrop Will Weigh on Fundamentals

Negative Global growth likely to slow in 2008

LEHMAN BRC)THERS


-

20

LBH I_ SEC07940 _ 393598

With Global Growth Slowing, we Would Expect Corporate Fundamentals to Deteriorate

(%)

12%

10%

7%

5%

2%

0%

1969-1970 1973-1974 1979-1980 1981-1982 1990

1111112 Quarters before Beginning ofRecession

::::::Lowest in Recession

Source: BEA, Commerce Department, Lehman Brothers Economics, Q4 Estimates,

LEHMAN BRC)THERS


2001

21

(%)

38%

19%

0%

(19%) ··················~··········································································u,n········································~

(38%) .·····

(57%) .................................................................................................................................................... .

Mar-89 Mar-92 Mar-95 Mar-98 Mar-01 Mar-04 Mar-07

LBH I_ SEC07940 _ 393599

However, Unlike the Previous Cycle, Leverage for Non-Financials is Starting Off at Lower Levels

2.5

1995 1997

Source: Lehman Brothers, Factset, Note,' 2007 Includes 4Q07 Estimate,

1999 2001

LEHMAN BRC)THERS

2003


2005 2007

10

8

6

4

2

0

1995 1997 1999 2001 2003 2005 2007

22

LBH I_ SEC07940 _ 393600

And the Liquidity Profile for Non-Financials Is Much Improved

Non-Financial CP outstanding has declined significantly as corporales have termed out I iabi I ities

($bn)

1,200 ................................................................................................................................................................................................................................................................................................................................... 325

1,100 ................................................................................................................................................................................................................................................................................................................................ 275

1,000

900 .. 175

800

700 ................................................................................................................................................................................................................................................................................................................................... 75

Jan-01 Nov-01 Sep-02 Jul-03 May-04 Mar-05

·····················Lehman Brothers Credit Index -Industrials+ utilities Amt. Outstanding

Source: Lehman Brothers, Federal Reserve.

LEHMAN BRC)THERS


23

Jan-06 Nov-06 Sep-07

-Non-Financial CP Outstanding

LBHI_SEC07940_393601

With Respect to Financials, Many Issuers have Taken Substantial Losses and Seen Significant Erosions in their Book Values

$U.S. in billions

AMBAC Freddie

Fannie Mae MBIA

Cmmtrywide Radian

Capital One MGIC

CIT Group Rescap

lndymac

Menill Lynch Morgan Stanley Credit Agricole

Bear Stearns Goldman Sachs

Lehman Barclays

Credit Suisse Nomura

AIG

Swiss Re

Allianz Metlife

Assured lNG

MuuichRe

Scottish Re

0 2 3 4

!Ill! Specialty Finance

11.9

6.5 :

5.0 . . ffimmm3.S ~3.7

0m®3.3 ~2.8. %1.0

0 5 10 15

m Broker-Dealers

0 3 6 9

:;:;:; Insurers I Reinsurers

Source: As of Apri/14, 2008. Lehman Brothers Research

LEHMAN BRC)THERS

6.3 6.0 .

5 6 7

24.5

20 25

14.8

12 15


UBS C itigro up

HSBC IKB Deutsche

Bank of America Wachovia

Deutsche Bank Bayerische Landesbank

WaMu CIBC

Societe Generale M izuho

Royal Bank of Scotland J.P. Morgan

West LB Taiwan Banks I Insurers

Sachen Landesbank D resdner Bank

ABN Amro Fortis

N atixis H SH No rdbank

Wells Fargo Sumitomo M FG

DZ Bank National City

Bank of China BNP Paribas

Caisse d'Epargne Sun Trust

Commerzbank National Bank of Canada

M itsubishi UFJ Bank of Montreal A me rica Express

Bank Hapoalim Alliance & Leicester

Royal Bank of Canada No rinchukin

Australia New Zealand Standard Chartered

Sumitomo Trust ICICI

Shinsei Bank of New York

DBS Group Deutsche Postbank AG

Desjardins Group

24

0 1 2 3 4 5

iiiiiiBanks

5.80

6 7 8 9 10

.................. oi3.37.1 -32;0 ... 12.4

37

LBH I_ SEC07940 _ 393602

A Critical Issue for Market Liquidity Will be How Quickly Issuers are Able to Repair Their Balance Sheets. Many Issuers have Raised Large Amounts ofNew Capital to Offset Their Losses

Equity Convertible Preferred

Domestic Capital Markets SLM- $1.5bn SLM- $1.0bn FNM- $7.0bn UBS- CHF 6.4bn C- $2.0 bn FRE- $6.0bn

GLE- $ 8.7bn BAC- $6.9bn WM- $8.5bn

WM- $ 1.5bn LEH- $ 4.0bn BAC- $6.0bn

WB- $3.5bn

Sovereign Wealth Funds MER- $5.0bn MS- $5.0bn BSC- $1.0bn C- $14.4bn UBS- CHF 13.0bn

Long-Term MER- $1.2bn C- $5.6 bn Domestic Investors MBI- $1.0bn MER- $6.6 bn

Source: Lehman Brothers equity research. Note: Mandatory convertible preferred treated as a convertible. MER- $600mn option to buy stock is considered as exercised. UBS- Treasury stock reissuance and stock dividend is treated as equity issue.

LEHMAN BRC)THERS


25

LBH I_ SEC07940 _ 393603

In Particular, the Cumulative Actions of the Fed and Other Institutions will Ease Funding Constraints on Highly Rated Assets Owned by Banks and Brokers, which Removes a Key Risk for Those Issuers

5,000

4,000

3,000

2,000

Additional Funding I Investment ~$700bn

---------~----------( "'\

New Investment in

Financing for Banks & Brokers Securities

1,ooo ................................ * ...................... < ....... ,,..... _ _.A .... _ ..... \ ( \

0····~···

TAF

.. TSLF

1'_!'/_!'/_!'/_!'/_!'/ --

PDCF

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

GSE FHLB Capital Investment

Reduction Authority Increase

Source: Lehman Brothers Economics, Lehman Brothers Securitized Products Strategy.

Estimate of Mortgage Assets Held by Banks & Brokers

$3,000bn

$270bn

US Banks/Thrifts Broker/Dealers

!IIIII Agency 11111 AAA Priv. Label

·•·• Comm MBS + Loans

AgencyMBS$4200bn

Commercial MBS$700bn

Amount Outstanding- EOY2007

Note: PDCF Size is unlimited Figures represent estimates of financing that is likely to be used Mid-point of range used for Broker/Dealer Mortgage Holdings Estimate

LEHMAN BRC)THERS


27

LBH I_ SEC07940 _ 393605

However, it is Important to Note that Less Diversified Financials have Outsized Exposures to Real-Estate Lending. Thus, the Fundamental Outlook Across Subsectors is Not Uniform

70%

60%

50%

40%

30%

20%

10%

0% I ...... •• BAC C JPM CMA FHN MI MfB SNV TCB ZION

Integrated Providers MidCap Banks

iii!CRE

Source: Lehman Brothers, SNL Financials,

LEHMAN BRC)THERS


::::: Cons tr & Land Dev

28

BBT FlfB KEY NCC PNC RF STI USB WB WFC

Super Regional Banks

llli Multi-Family

LBH I_ SEC07940 _ 393606

Overall, as the Market Struggles with Liquidity and Asset Quality Issues and Fundamentals Deteriorate Across Industrials Due to Weaker Growth, We Expect Default Rates to Pick Up From Multi-Year Lows

(%)

0.0%

1.2%

2.4%

3.6%

Dec-92 Dec-94 Dec-96 Dec-98 Dec-00

-Real GDP% YoY(LHS) (Inverted)

Source: Lehman Brothers, Federal Reserve, Moody's.

LEHMAN BRC)THERS


29

(%)

10%

...................... 6%

4% Estimate

for Defaults

Dec-02 Dec-04 Dec-06 Dec-08

.................... HY Default Rate (RHS)

LBH I_ SEC07940 _ 393607

So the Fundamental Backdrop Is Unlikely to Be Supportive Going Forward ... What about the Technical Backdrop?


LEHMAN BRC)THERS

Negative As growth slows, fundamentals to deteriorate


30

LBH I_ SEC07940 _ 393608

In Recent Years, a Large Amount of Debt has been Raised in Segments of the Market where Liquidity has Declined

($bn)

1,200

960

720

480

240

2001

1. Source: Lehman Brothers.

2002

LEHMAN BRC)THERS

2003

!Ill Fixed


2004 2005 2006 2007

''''Hybrids ,,,, Floating '' Extendible

31

LBH I_ SEC07940 _ 393609

As a Result, We Estimate Risk-Adjusted Supply to Be up Significantly

(%)

100%

80%

60%

40%

20%

0%

1111 Extendible

Source: Bloomberg.

2006

1. Uszng szmzlar Mzx to 4Q07.

:::: Floating

2. Approxzmatzon uszng spread duratzon.

LEHMAN BRC)THERS

2007

Fixed


2008E

l8i Pref.

33

($bn)

1,600

1,280

960

640

320

0

2006 2007 2008E

LBHI_SEC07940_393611

In Line with Expectations, Fixed Issuance in the First Quarter has Outpaced 2007 and Will Likely Remain Strong as Other Sources of Funding Remain Tight

200 .

180

160

140 ....................................................................................................................... .

120

100

80

60

40

2

: II

1Q.2007- $110 bn 1Q.2008- $169 bn

1Q 1997 1Q 1998 1Q 1999 1Q 2000 1Q 2001 1Q 2002 1Q 2003 1Q 2004 1Q 2005 1Q 2006 1Q 2007 1Q 2008


LEHMAN BRC)THERS


34

LBHI_SEC07940_393612

On the Demand Side, Inflows from Abroad have Slowed and Will Likely Remain Biased Towards Equities

(bn) 40 ........................................................ .

32

24

16

8

0

Treasury

11111!2006

Agency/ MBS

Fixed Income 90%

Corporate

Equity 10%

::::::2007

Equities

($bn)

400

320

240

160

80

0

Equity

1111112007

Corporate

::::::2008

While official institutions have diversified away from fixed income assets, given the current size of equity exposure there is scope for further diversification. Assuming an fixed income/equity shift to 85%/15% and a $130bn slowdown in official flows(l), foreign purchases of US corporate bonds would decline by $50bn in 2008

Source: Lehman Brothers; TIC.

LEHMAN BRC)THERS


35

LBHI_SEC07940_393613

The Drop in Synthetic CDO Issuance Will Result in a Further Decrease in Demand for Credit Risk

+ We expect Synthetic COO Issuance to decline by approximately 60% in 2008 due a combination of limited investor confidence in structured products and rating agency models

+ A 60% drop in issuance and decreased leverage on new deals would result in approximately a $290bn drop in 5year equivalent notional demand for risk

Global Synthetic CDO Issuance

($bn)

45

36

27

18

9

0

2000 2001 2002 2003 2004 2005 2006 2007 2008E Source: Lehman Brothers, Intex, IFR, Moody's, S&P

($bn)

375

300

225

150

75

0

Synthetic CDO Issuance -Delta-Adjusted 5-Year Equivalent

Down $290bn

2007 2008E

Note,' Synthetic issuance only includes only public transactions that were in funded format 2008 Estimate is based on a projected decline of 57% in cash and 50% in synthetic transactions,

LEHMAN BRC)THERS


36

LBHI_SEC07940_393614

In addition, Stressed Financial Issuer Balance Sheets will Likely Continue to Weigh on Demand for Risky Assets

100 ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.· 300%

90 .

50

40

10

0

1987 1990 1993 1996

illllllllllllll Reser~($ bn)

LEHMAN BRC)THERS


250%

200%

150%

100%

50%

1999 2002 2005

37

LBHI_SEC07940_393615

Putting it All Together, the Supply I Demand Imbalance Will Likely Continue To Weigh On Credit

(bn)

2,000

1,600

1,200

800

400

0

2006 Source: Lehman Brothers. Note: Approximation using spread duration.

LEHMAN BRC)THERS

2007


iiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiillllll,iiiliii~lliliii-~~iiiilillliiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiiii

+International Demand: Down $50bn

+ Synthetic Demand: Down $290bn

+Front End Demand: Down $280bn

+Redemptions: Down $75bn

+Total: Down $600bn

2008E

38

LBHI_SEC07940_393616

No Discussion of the Technical Backdrop Would be Complete Without Looking at Spreads


LEHMAN BRC)THERS



39

-Negative Large supply I demand imbalance to persist

LBHI_SEC07940_393617

Across Sectors, Spreads Remain Close to Their Widest Levels in Cash

... since 2002 and investors must put much more focus on relative value going forward

(bp)

560 ·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.· .. ·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.

480 .......................................................... .

400 l 1

240 .

. J.

160 .····

80 .

0 .····

"' -; ... "CC "' -; .... ~ 0 = " "' .... 0 ;§ ~ § :s " 0 = .. "' ... ..... -; "'

... = "' "§ u 0 = i ui .... .. e " u ~ e

0 u = 0 u


LEHMAN BRC)THERS


... ~ 0 0 ..e "' " E-<

·::;:::·

. . . . . . . . . . . . . . . . . . . . ................ :;;;~~;:: .. .

= "' "' ~ " " "' ;§ -; ·;::: ..

~ ~ "' ~ ~

-; ..... 0 .. " ·o .. ·;::: "' .... ·= .. ~ ..... 1;] ~ -; = ~ .. .... = .... = .... .. ~ ~ ~ .,§ 0 "CC .a ~ 0 e ~ .s .e .s ·~ = "' .. 0 ~;::: = z u .... 1;] .. .... .... " " .f.S E-< .; "' = 0 0 .. .e ....

40

LBHI_SEC07940_393618

However, While Spreads Are Much More Supportive Than Last Year, All-In Yields are Essentially the Same

(bp)

700

0-2 Years 2-4 Years 4-6 Years 6-8 Years 8-12 Years O~r 12 Years

18! Treasury ::::Swap :::: Credit Risk


LEHMAN BRC)THERS 41

(bp)

300

200

100

0

(100) .

(200)

(300) .

(400) .

0-2 Years 2-4 Years 4-6 Years 6-8 Years 8-12 Years

Change (137bp) (54bp) (27bp) 24bp 28bp in Yields

vs. 12/06 !Ill Treasury ,,,,,Swap '''' Credit Risk

Over 12 Years

22bp

0


LBHI_SEC07940_393619

And in Derivatives, Spreads Have Retraced a Substantial Portion of the Recent Widening

18 .

16 ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·. Over half the names have retraced over 60% of ·.····

14 .·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· the widening from early-January to mid-March .····

12 .

10 ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.

8 .

6

4

2 ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.

0············································································

0% - 5% - 10% - 15% - 20% - 25% - 30% - 35% - 40% - 45% - 50% - 55% - 60% - 65% - 70% - 75% - 80% - 85% - 90% - 95% -10% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%

70%

60%

50%

40%

30%

20%

10%

0°/o


IG

LEHMAN BRC)THERS


!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

HVOL CMBXAAA ABX07-1 AAA

42

LBH I_ SEC07940 _ 393620

In Addition, Corporate Credit has not Cheapened as Much as Some Other Spread Sectors. As the De leveraging Continues we Believe Spreads Will Need to Remain at Levels That Deliver Attractive Returns Even at No or Low Leverage

(bp)

900 800 700 600 500 400 300 200

... .... 100

····.·.· .. .. ;:.:·:

0

Jun-99

Asset Class

AB S Home Equity

ABSAuto

Ius Credit

CMBS

AB S Credit Card

Source: Lehman Brothers. Note: As of 4114/2008

Jul-00 Aug-01 Sep-02

-US Credit- OAS

·········· ABS Credit Card- OAS

· · · · · · · · · · ABS Home Equity- OAS

Average Rating

AAA

AAA

Al/A2

AAA/AA1

AAA

LEHMAN BRC)THERS


Oct-03 Oct-04 Nov-05

................... US Mlrtgage Backed Securities - OAS

-ABS Auto- OAS

~ CMBS: Erisa Eligible- OAS

Wides Since 2001 OAS (bp)

855 851

403 382

268 245

486 330

263 251

43

Dec-06 Jan-08

Chg Since 12/31/07 (bp)

+373

+168

+63

+161

+90

LBH I_ SEC07940 _ 393621

Bringing it all Together, what is the Outlook for Different Parts of Credit ?


LEHMAN BRC)THERS



44

-Negative Large supply I demand imbalance to persist

Positive Cash Spreads near multiyear wides. However, liquidity situation needs to improve further to get full benefit

LBH I_ SEC07940 _ 393622

We Remain Generally Bearish on Investment Grade Credit Despite Current Valuations. However, this has Become a More Bifurcated View.

High quality financials, especially money center banks and brokers, have seen significant widening and provide attractive value at these levels. We remain cautious on independents and regional banks due to ongoing asset quality concerns

(bp) 350 ·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·. ;;

300

250

200

150

100

50

Apr-03

70% 60%

50% 40% 30% 20%

Sep-03

10% .. . .. . 0% ... :-:·:·:·:·:·:·:·:·: ... ---------- .... -~~~~~~~~~~ ....

Mar-04 Sep-04 Mar-05 Sep-05 -Invest. Grade: Industrial- OAS

BAC C JPM

Integrated Providers

CMA FHN Ml MfB SNV TCB ZION

MidCap Banks

IIIICRE


LEHMAN BRC)THERS


:,:,: Cons tr & Land Dev

45

Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 ·········· ln\es t. Grade: Finance - OAS

BBT FlfB KEY NCC PNC RF STI USB WB WFC

Super Regional Banks

1111 Multi-Family

LBH I_ SEC07940 _ 393623

Given Our Expectations for Slower Growth we Believe That the Credit Cycle Turn Will Continue. We Thus Expect More Cyclical Sectors to Remain Under Pressure.

(bp)

300

250

200

150

100

50

Dec-05

400

200

0

(200)

(400)

(600)

4Q2000

Jun-06 Dec-06

-Imest. Grade: Consumer Cyclical- OAS

4Q2001 4Q2002 4Q2003

Jun-07 Dec-07

··················· Irnest. Grade: Consumer Noncyclical- OAS

........................................................ i,·i .. i •. i .. i •. i .. i •. i .. i,·.· . . . . IJIJ Ill

.11~:~:~:~: ... 11~~~~~~~~~. ·········~·············~·············:::::::::: .•. 1:;:;:;:;:····~· • (lj ··········~·r ::::~~~

4Q2004 4Q2005 4Q2006 4Q2007

111111 Consumer Cyclical ::::::: Consumer Non-Cyclical


LEHMAN BRC)THERS


46

LBH I_ SEC07940 _ 393624

We Recommend Negative Basis Trades for Investors with Access to Cheap Funding and for Those Looking to Source Convexity in This High Volatility Environment

10

(30) ·.·····

(70) .

(90)

(110) .

Jul-07

Profit

Loss

Source: Lehman Brothers. Note: Assumes 40%Recovery

Aug-07

Credit Rallies

LEHMAN BRC)THERS


Oct-07 Dec-07 Feb-08 Mar-08

Credit Defaults

Credit Deteriorates

47

LBH I_ SEC07940 _ 393625

In High Yield, the Default Cycle will be Unique as we are Coming Off of a Period of Lenient Lending Standards. A Combination of a Worse Credit Profile and Increased Issuer Flexibility will Likely Lead to Lower Recoveries for Unsecured Bonds.

20%

18% .

16% .

14%

12%

10% .

8% .

6%

4%

:: &llo•••••••••••·•••••lllllltl 01104 08/04 03/05 10/05 05/06 12/06 07/07 02/08


LEHMAN BRC)THERS


48

100

CCC& Lower form

80 more than

20°/o of index

60

40

20

0

1993 1995 1997 1999 2001 2003 2005 2007

LBH I_ SEC07940 _ 393626

At Current Levels, We Prefer Leveraged Loans to High-Yield Bonds Given Their Structural Seniority and Low Dollar Price

100%

80%

60%

40%

20%

Jul-06 Mar-07 Jun-07 Jun-07 Oct-07 Feb-08

1111<90 {90-98 illllll98-100


LEHMAN BRC)THERS


49

7% illllll% ofLoans

6%

5%

4%

3%

2%

1%

oo/o ....... ~ ....... 11118 ················~·181·······&&··~·

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

4%

4%

3%

3%

2%

2%

1%

1%

0%

0%

r:al% ofBonds

.................... Mean-32% St Dev -17% Count = 1603 Issues

10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

LBH I_ SEC07940 _ 393627

Within Structured Credit, AAA Tranches of CLOs present the Best Opportunity for Investors with Stable Funding. While CLO's are Fundamentally Different from ABS CDO's .....

Collateral

Asset Diversity

CDO within CDO

Leverage/Subordination

Cash flow Triggers

Impact of Asset Downgrades

Excess Interest and Deleveraging

Portfolio Management

Modeling


LEHMAN BRC)THERS

CLO

Primarily high yield corporate

senior secured loans

Highly diversified, typically 150-200 issuers across different sectors

"Structured finance buckets" are capped at 3-5% - Managers rarely use more than

1-2%

Rating agencies require more par subordination for HY collateral ( ~8% equity)

Waterfall structure diverts cashflow to senior holders if coverage tests fail

Caa/CCC assets in excess of 5. 0-7.5% are carried at market value for OC purposes (typical

size is 0-2% now

Higher excess interest means faster deleveraging in the event of an OC breach

Almost all are actively managed

Simpler

50


ABSCDO

Primarily HELs

Concentrated in

residential real estate, consumer risks

10 to 3 0+% of portfolio consist of other AB S CDO tranches

Rating agencies require less par subordination for IG collateral (<1% for HG and ~5% for

Mezz eguity) Transactions from 2006 were increasingly

without triggers

OC haircuts kick in when downgrades to BB and B are in excess

Very slow deleveraging, especially with HG

assets

Some are static or partially managed

Complex (re-securitization)

LBH I_ SEC07940 _ 393628

Spreads have Widened Substantially In Line With other Structured Products, Even Though AAAs are well Protected Against Principal Losses

(bps)

400

350

300

250

200

150

100

50

0

Mar-98 May-99 Jun-00 Jul-01 Aug-02 Sep-03 Oct-04 Nov-05 Jan-07 Feb-08

-AAA .,.,.,.,.,.,.,.,.,.,.AA

+ Recent widening seems to have been driven by concerns over investors' ability to finance AAA assets going forward

+ Even under extreme stress scenarios, AAA CLOs are well protected against principal losses. Even at 60% average recovery, annual default rates must be greater than 3 1% per annum to break AAACLOs

Source: Lehman Brothers. 1. 2006- 2007.

LEHMAN BRC)THERS


51

40 50

Insurance

Banks

60-70%

60

Loan Recovery (% )

Other

5-10%

70

Asset

Managers

/Levered

80

LBH I_ SEC07940 _ 393629

As Growth Slows and Fundamentals Deteriorate, Junior Parts of the Capital Structure Should Continue to Underperform Both Within Issuers

900

400

12/31 01125

~CDXHY9

Source: Lehman Brothers, Bloomberg.

02/20

LEHMAN BRC)THERS

03/16


550

500

300

250

04/11

52

280 ............................................................................................................................................. 2,500

240

2,000

200

1,500 160

120 1,000

80

500

40

0 ............................................................................................................................................. 0


~AAA

LBH I_ SEC07940 _ 393630

And Across Asset Classes

280 .............................................................................................................................................. 2,500

0 ~~~~::::::'' ........................................................................ 0


-AAA .................. ··BBB- (RHS)


LEHMAN BRC)THERS


53

80 20

·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· .. ·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.··.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.·.· 8 50

Dec-07 Jan-08 Feb-08 Mar-08 Apr-08

-AAA .................. ··BBB-

LBHI_SEC07940_393631

And the Best Shorts Are Likely to Be Those That Could Actually Experience Losses Rather Than Those That Are Simply Trading Too Tight

bp

200

150

100

50

0

Mar-06 Sep-06 Mar-07 Sep-07 Mar-08

( 0-3% > 3-7% 11111117-10% :~:~:~: 10-15% ( 15-30% 111111130-100%

Similar to Last Cycle

Liquid IG Severe 0%-3%

Severe, Credit Cycle

Wiped Out

Extremely Severe

Credit Cycle

Wiped Out

Slight

Tranches Principal Loss (7Y) _____ .....;;..._ _________ _

./ 3%-7%

7%-10%

10%-15% &Above

Liquid 0%-10%

HY 10%-15%

Wiped Out

Principal Loss Heavy Loss

./ ./

./ ./

Wiped Out Wiped Out

Tranches------------~----------~--------~------Wiped Out Wiped Out Wiped Out

(5Y) 15%-25% Heavy Loss Wiped Out Wiped Out

25%-35% ./ Wiped Out Wiped Out

35%-100% ./ Just Touched Significant Loss

Source: Lehman Brothers. Credit cycle data based on Moody "s default data for JG and HY Regular recession scenarios are run on flat periodic default rates. Front I back loaded scenarios assume linearly decreasing I increasing d_'{[f!;.ult rates with a minimum of 0% and a maximum of two times the periodic default rate. ",/"" stands for non- impairment in the tranche.

LEHMAN tlR()THERS 54


LBH I_ SEC07940 _ 393632

Concluding Thoughts

Negative Global growth likely

to slow in 2008

Negative As growth slows,

fundamentals to deteriorate

Large supply I demand Negative

imbalance to persist

Cash Spreads near multiyear wides. Positive However, liquidity situation needs to

improve further to get full benefit

LEHMAN BRC)THERS 55


• Deteriorating macro backdrop combined with a large demand I supply imbalance should prevent spreads from rallying materially

• Aggressive central bank action should lead to liquidity normalization in the intermediate term, but underlying asset quality issues will remain

• Ability of spreads to rally will be a function of the amount of economic damage done by the credit crunch

LBH I_ SEC07940 _ 393633

This material has been prepared by Credit Trading and is not a product of Lehman Brothers Research Department. It is for informational purposes only. Lehman Brothers makes no representation that the information contained in this document is accurate or complete. Opinions expressed herein are subject to change without notice. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the issuance of this document. Under no circumstances should this document be used or considered as an offer to sell or a solicitation of an offer to buy any financial instrument mentioned in it. The products mentioned in this document may not be eligible for sale in some states or countries, or suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Clients are advised to make an independent review regarding the economic benefits and risks of purchasing or selling the financial instruments mentioned in this document and reach their own conclusions regarding the legal, tax, accounting and other aspects of any transaction in the financial instrument in relation to their particular circumstances. Lehman Brothers enters into transactions on an arm's length basis and does not act as advisor or fiduciary to its counter parties except where a law, rule or written agreement expressly provides otherwise. Lehman Brothers and/or its affiliated companies may make a market or deal as principal in the financial instruments mentioned in this document or in related securities, options or other derivative instruments based on them. In addition, Lehman Brothers, its affiliated companies, shareholders, directors, officers and/or employees, may from time to time have long or short positions in the financial instruments, including loans, securities or in options, futures or other derivative instruments based on them. One or more directors, officers and/or employees of Lehman Brothers or its affiliated companies may be a director of the borrower or issuer mentioned in this document. Lehman Brothers or its predecessors and/or its affiliated companies may have acted as agent or arranger with respect to the loans of the borrowers mentioned in this report, and may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking, lending or other services for, or solicit investment banking or other business from any company mentioned in this document. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. ©2008 Lehman Brothers Inc. All rights reserved. Member of SIPC.

LEHMAN BRC)THERS


56

LBH I_ SEC07940 _ 393634

Credit Outlook - Stanford University

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