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Slide 1: CONFIDENTIAL Global Markets Disruptions Reinventing Brenton Woods Salzburg, Austria Document Date Anthony M Santomero, Senior Advisor McKinsey & Company This report is solely for the use of client personnel. No part of it may be circulated, quoted, or reproduced for distribution outside the client organization without prior written approval from McKinsey & Company. This material was used by McKinsey & Company during an oral presentation; it is not a complete record of the discussion. June 13, 2008
Slide 2: NYO-AAA123-20080607- Unit of measure LOSSES FROM THE CURRENT CRISIS WILL BE SUBSTANTIAL • Current estimates of eventual direct credit losses vary widely and range up to $2 trillion. • We believe $800 billion is a reasonable estimate under the assumption of a mild recession (little or no growth through 2008 in the US with a gradual recovery through 2009). –Of this, ~50% come from residential mortgages and home equity products, ~15% from commercial mortgages, ~15% from consumer credit, and the rest from corporate loans. –The direct losses would thus represent ~5.9% of U.S. GDP, which would make the current correction worse than the S&L crisis (4% of GDP) but far less severe than the Japanese banking crisis (15% of GDP) –The magnitude of the indirect effects is much harder to predict (e.g., Hatzius at Goldman predicts a 1-1.5 percentage point decline in U.S. GDP growth over the next year as a result of the contraction of bank balance sheets). Working Draft - Last Modified 6/7/2008 11:15:24 AM Printed • Losses borne by banks and securities firms globally would be ~$550 billion, with ~$420 billion from US credit exposures and ~$130 billion from European credit exposures –$320 billion of losses had been announced as of May 1, or roughly 60% of projected credit losses in this scenario –Most losses recognized thus far have been mark-to-market write-downs of securities, but actual credit losses and provisions to date remain modest and are likely to increase –Losses due to US residential mortgage exposures may erase ~4.5 years of profits earned by the mortgage industry * Footnote Source: Source 2
Slide 3: NYO-AAA123-20080607- AN $800 BILLION ESTIMATE IS REASONABLE IN A MILD RECESSION Unit of measure Estimated cumulative credit losses: today’s crisis $ Billions Estimated cumulative credit losses: past crises % of GDP 2,000 35 35.0% Working Draft - Last Modified 6/7/2008 11:15:24 AM Components of credit loss • Residential mortgages • Commercial real estate • Credit cards and auto loans • Commercial and industrial loans • Corporate bonds 30 25 1,280 1,156 945 800 625 15 15.0% 20 Printed 500* 400* 10 5.9% 5 4.0% 319 0 Write-offs Jan % of GDP to Hatz date ius* * 2.4% 3.0% Merrill Lynch* McKinsey (Bounce Back scenario)** McKinsey IMF (mild recession scenario)** Goldman Sachs McKinsey Allianz (End of an Dresdner Era scenario)** US Savings McKinsey Japan and Loans (mild (1986-95) recession scenario)** 3.7% 4.6% 5.9% 7.0% 8.6% 9.6% 14.8% $B $275 $800 * Footnote in late 2008. End of an Era scenario assumes little or no growth in 2008 and through the first half of 2009 with recovery beginning in the second half of 2009. Source: Source Sources: McKinsey analysis, IMF, Goldman Sachs, BEA U.S. Dept. of Commerce * U.S. residential mortgages only ** Note: Mild recession scenario assumes little or no real economic growth in 2008 and economic recovery begins in early 2009. Bounce Back scenario assumes Bounce Back begins ban king crisi s $750 Emerging markets banking crisis (1997-98) $400 3
Slide 4: 00 NYO-AAA123-20080607- ROUGHLY TWO-THIRDS OF US CREDIT LOSSES ARE LIKELY TO COME FROM RESIDENTIAL AND COMMERCIAL MORTGAGES Unit of measure $ Billions 800 130 Working Draft - Last Modified 6/7/2008 11:15:24 AM 68% of total 130 120 280 140 Printed Subprime residential Goldman Sachs (3/7) IMF 330** Non subprime residenti al170** 188 Commercial mortgage 183 Consumer credit* 223 Corporate credit*** 251 Total 1,157 375 240 20 120 945 * Losses incremental to normal expected losses * Footnote ** Assuming that two-thirds of residential mortgage losses are from subprime mortgages Source: Including highSource and leveraged loans *** yield bonds 4
Slide 5: 1 NYO-AAA123-20080607- BANKS ARE EXPECTED TO INCUR ~$550 BILLION IN CREDIT LOSSES, Unit of measure HALF OF WHICH HAVE BEEN REALIZED MORE THAN ~$550 billion in credit losses expected for banks, out of ~$800 billion total losses for financial institutions* Expected total write-downs for financial institutions $ Billions So far banks have realized more than ½ of their losses Current write-downs per bank $ Billions, April 30, 2008 Citigroup 41 38 32 15 15 13 13 10 10 124 309 Working Draft - Last Modified 6/7/2008 11:15:24 AM ~800 ~120 ~130 ~130 550 Banks 250 Other financial institutions UBS Merrill Lynch Bank Of America RBS Morgan Stanley Printed ~420 HSBC JPMorgan Chase Credit Suisse Resid. Real Estate Com. Credit Cons. Credit Com. Real Estate Total Other Total * Losses for global financial institutions from U.S. borrowers Source: Source Source: Company reports, IMF estimates, Goldman Sachs estimates; Bloomberg; team analysis * Footnote 5
Slide 6: 54 NYO-AAA123-20080607- BUT THE NUMBERS KEEP CHANGING: ASSET WRITEDOWNS AND Unit of measure LOSSES AT BANKS AND SECURITIES FIRMS KEEP RISING Cumulative asset writedowns and credit losses by fiscal quarter* Cumulative asset writedowns and credit losses to date by institution** Citigroup UBS Merrill Lynch HSBC IKB Deutsche Bank of America Royal Bank of Scotland Morgan Stanley JPMorgan Chase Credit Suisse Washington Mutual Deutsche Bank Wachovia Credit Agricole HBOS PLC Fortis Bayerische Landesbank ING Mizuho CIBC Wells Fargo Societe General WestLB Dresdner Lehman Brothers E*Trade Natixis Barclays Lloyds Bear Stearns Nordbank HSH National City Goldman Sachs Others USD billions 38 37 16 15 15 13 10 10 9 8 7 7 7 7 7 6 5 4 4 4 4 4 3 3 3 3 3 3 3 3 3 20 43 Working Draft - Last Modified 6/7/2008 11:15:24 AM 379 208 Total losses to date: USD 379 bn, including • ~USD 320–330 bn in asset writedowns • ~USD 50–60 bn in credit losses Printed 49 4 2Q 07 3Q 07 4Q 07 1/2Q 08 * Footnote Source: 54 Source 6
Slide 7: 54 NYO-AAA123-20080607- BANKS AND SECURITIES FIRMS HAVE ADDED CAPITAL TO REBUILD Unit of measure THEIR BALANCE SHEETS Cumulative capital infusions over time Cumulative capital infusions by institution Citigroup UBS Royal Bank of Scotland Bank of America Merrill Lynch IKB Deutsche Wachovia Washington Mutual Barclays USD billions 43 27 24 17 16 13 11 10 10 9 9 9 8 8 7 6 6 5 4 3 2 2 2 2 2 1 1 1 7 Working Draft - Last Modified 6/7/2008 11:15:24 AM 263 Credit Agricole National City Societe General HBOS PLC WestLB Fannie Mae JPMorgan Chase Printed 127 Freddie Mae Morgan Stanley Lehman Brothers Canadian Imperial (CIBC) Cumulative capital raised to date: USD 263 billion 53 10 9/30/07 12/31/07 3/31/08 5/20/08 HSBC Deutsche Bank E*trade Credit suisse Sovereign Bancorp Sumitomo Mitsui Gulf International Natixis Other 4 6/30/07 * Footnote Source: Source 7
Slide 8: 93 NYO-AAA123-20080607- HOW FAR DO WE HAVE TO GO? THE BANKS ARE NOT THERE YET! Unit of measure Impact on global banks 3 year estimate (2008-2010); Capital, $ billions ~80 ~550 ~132 Corresponds to $80 billion in assets sold 500-600 ~232 ~8 300-350 Total book equity of the top 400 US commercial banks ~$1.3 trillion (2007) ~165 Possible actions going forward Working Draft - Last Modified 6/7/2008 11:15:24 AM • Reduce capital through • Cut dividends further • Continue raising capital • Reduce assets on balance sheet to free up capital retained earnings* Capital impact Shortfall for of expected total 3 years future write-down loan origination since Jan-07 given shutdown of securitization markets Capital required Tax shield due to SIV’s/ reduction from conduits added write downs to balance sheet Total capital shortfall Capital raised since Jan-07 Capital freed up through financial asset sales Capital shortfall assuming return to on balance sheet structure Printed McKinsey estimates Estimated based on projected MBS, ABS and CDO demand from credit worthy borrowers, which cannot be met Assuming a Estimated based on $1.6 30% blended Trillion in SIV’s tax rate and conduits added to banks balance sheets (~$800 B from US banks and ~ $800 B from European banks) Bloomberg estimates of capital raised by banks since Jan-07 Could increase Banks have further due to been able to unload ~$80 B in • Capital requirement assets, freed increases capital assumed based on 10% • Need to reduce leverage ratios** capital requirements * Retained earnings expected to be a total of $330 billion for 2008-20010, assuming a reduced dividend payout ratio at 2001 level (~40%, cf. 2006 average payout ratio of 55%) over net income of top commercial banks worldwide, estimated to be similar to 2001 to 2003 net earnings ($550 billion) ** * Reducing leverage ratios back to 2002 values would require an additional $100-200 billion in capital Footnote Note: Total assets of top 400 largest banks in U.S. amount to ~$22 trillion Source: Source Source: IMF; Bloomberg; SNL financial database; team analysis 8
Slide 9: NYO-AAA123-20080607- THERE ARE THREE REQUIREMENT FOR A MEANINGFUL RECOVERY Unit of measure Banks’ balance sheets need to be cleaned up –Between 2002 and 2007, investment banks leverage (assets/equity) has risen 40% while universal bank leverage has risen 22% –So long as equity capital is available, banks will emphasize capital raising over asset sales –So far, banks have recognized ~1/2 of their total estimated losses (estimated at ~$550 billion), while they have raised ~1/3 of the required new capital (~$230B raised) to reduce leverage, cover expected losses and return to a largely on balance sheet model  Investor confidence needs to return –Structural changes in CLOs coupled with reduction in cost of funding required to allow CLOs to be competitive –Over time, CLOs will begin to set pricing again. By 2010, the cost of funding will come down to ~L+75. The required structural changes will lead to the BB CLO floor price increasing from ~165 bps in H1 2007 to 250-270 bps in 2010  Liquidity must return to the credit markets –Investors have moved large amounts of capital to “safe havens” including money market funds and treasuries. Looking for higher yields, this money is poised to return to the market sooner or later –Macroeconomics factors – in particular the weak U.S. dollar attracting foreign investors – will contribute to an improved liquidity situation, increasing the flow of foreign funds flow into the U.S. –Sponsors with $804B in capital to invest will continue to test the credit markets Working Draft - Last Modified 6/7/2008 11:15:24 AM Printed * Footnote Source: Source 9
Slide 10: NYO-AAA123-20080607- INTERVIEWS SUPPORT THE RETURN OF CLOs AND CHANGES IN Unit of measure STRUCTURE AND FUNDING COSTS CLOs will return, although in lower volumes • “Structured credit will come back… Investors will demand the securities… just expect more transparency” • “When it’s all said and done, people will realize CLO structures worked… you won’t see losses on AAA/AA tranches like you did for RMBS” • “In a few years, expect to see CLOs setting the price again … I’d say around 250bps” • “Even when CLOs come back, it won’t return back to 1H2007 levels” CLOs will have simpler, more transparent structures than before • “CLOs will come back but with much simpler structures … expect structures to ultimately get nearly as complex as 2007” • “Changes will come from the structure of the underlying assets … less leverage and higher covenants are guaranteed” • “Investors will require better collateral, no covenant light or second liens in the pool” • “Leverage of hedge fund equity will come back to near 2007 levels but with pricing at L+100 or higher” Funding costs expected to come down to ~L+75 bps • “CLO cost of funds won’t stay where they are … L + 75 bps or less is doable in a few years” • “AAA tranches will come back … traditional buyers, such as international investors, demand AAA paper, more than exists through corporate issuance” * • “The Street has a very short memory… in the end, pricing will come down” Footnote Source Source: Source: Interviews; McKinsey 10 Working Draft - Last Modified 6/7/2008 11:15:24 AM Printed
Slide 11: NYO-AAA123-20080607- CLO STRUCTURE IS EXPECTED TO CHANGE GOING FORWARD Unit of measure Typical CLO structure prior to crisis Asset Liability Potential CLO structure going forward Asset Liability Working Draft - Last Modified 6/7/2008 11:15:24 AM BB 65-75% 70–75% 5-7% 5-7% 2-4% 2-4% 6-8% 65-70% AAA AA A BBB BB Equity BB 60-80% 10-20% B 20-40% 5-10% 10-15% AAA B Second lien AA ≤BBB Equity 10-20% 5-15% Printed Expected changes • Higher quality underlying • • • * Footnote Source: Interviews; McKinsey Source Source: assets Tranche consolidation Larger equity tranche More protective covenants 11