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Latent and Active Catalysts – Three Threats
2
Slowdown inChinese Demand
Central BankPolicyMissteps
Sovereign Debt Crisis
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Slowdown in Chinese Demand
3
579
1113151719212325
Mar-94
Dec-94
Sep-95
Jun-96
Mar-97
Dec-97
Sep-98
Jun-99
Mar-00
Dec-00
Sep-01
Jun-02
Mar-03
Dec-03
Sep-04
Jun-05
Mar-06
Dec-06
Sep-07
Jun-08
Mar-09
Dec-09
Sep-10
Loan Growth
GDP Growth
7
9
11
13
15
17
19
Jun-06
Sep-06
Dec-06
Mar-07
Jun-07
Sep-07
Dec-07
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
Jun-10
Sep-10
Dec-10
Chinese RequiredReserve Ratio
Chinese Required Reserve Ratio for Major Banks
Source: The People’s Bank of China; Bloomberg; Knight Research
Chinese Loan and GDP Growth (% Change YoY) • NYT article 2/2/2011 stating China is
poised to hike rates within one month
• Mixed PMI data recently; new 5M low
and second consecutive decline for
January
• Chinese press reported 2/1/2011 that
the PBOC may implement price controls
to stabilize inflation
• PBOC may be backing away from
differentiated RRR in 2011 as liquidity is
tight (around New Year)
• Salient Questions:
– Is China like Japan in that it absorbs
more global growth than it
provides?
– How much will the RE and banking
sectors be shielded from a
slowdown?
– Is it a normal cycle or a bubble?
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Central Bank Policy Missteps – Inflation and Credit Problemsvs. Job Growth
4
50
100
150
200
250
300
J-89
J-90
J-91
J-92
J-93
J-94
J-95
J-96
J-97
J-98
J-99
J-00
J-01
J-02
J-03
J-04
J-05
J-06
J-07
J-08
J-09
J-10
Income/ExpenditureDifferentialCommodity Prices
90
110
130
150
170
190
210
230
J-05
M-05
S-05
J-06
M-06
S-06
J-07
M-07
S-07
J-08
M-08
S-08
J-09
M-09
S-09
J-10
M-10
S-10
Income/ExpenditureDifferentialCommodity Prices
7
7.5
8
8.5
9
9.5
10
10.5
J-05
M-05
S-05
J-06
M-06
S-06
J-07
M-07
S-07
J-08
M-08
S-08
J-09
M-09
S-09
J-10
M-10
S-10
0
50
100
150
200
250
O-09
N-09
D-09
J-10
F-10
M-10
A-10
M-10
J-10
J-10
A-10
S-10
O-10
N-10
D-10
J-11
F-11
U.S. Inflation and Credit Eurozone Unemployment (%)
SOVXWE
Source: Marklt; Bloomberg; Knight Research
Source: Eurostat; Bloomberg; Knight Research
Source: Bureau of Economic Analysis; NYBOT; Bloomberg; Knight Research
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Makeup of European Spreads
5
• Market expectations are dependent on the prevailing belief in both the risks inherent in sovereigns on a stand-alone basis
and the mitigants associated with Eurozone membership. Both are moving targets, with the stand-alone spread defining
process being iterative in information and the risk mitigant factors subject to numerous political factors. Understanding the
catalysts that move these factors is key to understanding European sovereign risks.
• Reflects
• High levels ofindebtedness
• Aging population
• Higher marketsensitivity tosovereign risks
• Globalindebtedness
• Banking system risk
• Reflects
• Belief in fiscal unity
• Possibility ofcentral treasury
• Continued bailoutefforts
• Reflect Combinationof Both Cases
N
on-Externally Supported Spreads
EurozoneMembe
rship Mitigant
Observed
Markets
- =
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Risk Pricing in Peripheral Europe – A Return to Normal
6
Max EMU Member Spread to Bund (10Y, bp)Deterioration of Periphery Maastricht Treaty IndicatorsSince Euro Formation
As of 2/7/11
Source: Bloomberg; Knight Research
Greece Ireland Italy Portugal Spain
Maastricht Treaty
Budget Deficit -11.1 -2.9 -8.6 -4.1 -3.5
Debt/GDP 87.8 92.5 108.1 54.4 46.8
EMU Launch
Budget Deficit -3.3 2.7 -1.7 -2.8 -1.4Debt/GDP 94 48.5 113.7 51.4 62.3
Current
Budget Deficit -13.6 -14.4 -5.3 -9.3 -11.1
Debt/GDP 115.1 65.5 116 76.1 53.2
Since Maastricht Treaty
Budget Deficit -2.5 -11.5 3.3 -5.2 -7.6
Debt/GDP 27.3 -27 7.9 21.7 6.4
Since EMU Launch
Budget Deficit -10.3 -17.1 -3.6 -6.5 -9.7
Debt/GDP 21.1 17 2.3 24.7 -9.1
Source: EuroStat; OECD; Knight Research
0
200
400
600
800
1000
1200
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Maastricht Treaty
Euro Launch
Max Spread to Germany(bp)
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Europe Faces Rising Debt Burdens and Limited Fiscal Flexibility
7
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
10% 15% 20% 25% 30% 35% 40% 45% 50%
Interest Expense (% of GDP) *
IrelandGreeceSpainItalyBelgiumPortugalUS
Japan
Global Debt Rankings (USD)
European Debt Burdens
Country Debt (MM)
1) Japan 10,744,088
2) United States 8,998,373
3) Italy 2,122,356
4) France 1,684,882
5) Germany 1,656,882
6) United Kingdom 1,653,165
7) Spain 835,838
8) Canada 605,947
9) Greece 444,142
10) Belgium 423,532
• Italy and Spain are the largest debtors in the
periphery
• Italy is more heavily indebted with more
onerous rollover requirements
• Italy, Belgium, and Portugal have a high
sensitivity to funding costs * Represents interest expense if total debt were priced at current levels.
Tax Revenue (% of GDP)
More Fiscal Flexibility
Less Fiscal Flexibility
Bubble Size Represents Debt to 2011 Projected GDP
European Tax Revenues vs. Interest Expense
Source: Eurostat; World Bank; Bloomberg; Knight Research
As of 1/4/2011, Stressed Scenario: +700 over current bunds for Euro Periphery, 5% for US, and 4% for Japan
Greece Italy Ireland Portugal Spain Belgium US Japan
GDP 233,046€ 1,520,870€ 159,646€ 168,046€ 1,053,914€ 339,162€ 14,119,000$ 5,06$
Debt 293,755€ 1,557,670€ 94,975€ 137,696€ 607,956€ 310,873€ 8,890,643$ 10$
Average Rate Debt Burden % GDP 14.44% 4.19% 4.92% 5.23% 2.58% 3.19% 1.39% 1.40%
Stressed Scenario 12.46% 10.13% 5.88% 8.10% 5.70% 9.06% 3.15% 8.25%
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Growth Projections Seem Predicated on FiscalResponsibility Not Being Contractionary
8
Economic Growth Forecasts (YoY, % change)
2009 2010 2011 2012 2011 2012
United States –2.6 2.8 3.0 2.7 0.7 –0.3
Germany –4.7 3.6 2.2 2.0 0.2 0.0
France –2.5 1.6 1.6 1.8 0.0 0.0
Italy –5.0 1.0 1.0 1.3 0.0 –0.1
Spain –3.7 –0.2 0.6 1.5 –0.1 –0.3
Japan –6.3 4.3 1.6 1.8 0.1 –0.2
United Kingdom –4.9 1.7 2.0 2.3 0.0 0.0
Canada –2.5 2.9 2.3 2.7 –0.4 0.0
Projections
Difference from
October 2010 WEO
Projections
Source: WEO Update, January 2011; Knight Research
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EFSF – CDO Solution, Quasi-Treasury, or Debt Spiral?
Drawdown ofEFSF
Less EFSFFunding
Available
MoreIMF/Int’l
Involvement
NewHierarchy of
Debt
More DifficultMarket for
SovereignIssuance
Difficult
FundingEnvironment
9
Senior
• IMF/Int’l Loans• Domestic Bank
Deposits
• EFSF Loans• Sovereign Bonds
Junior
• Bank CapitalBorrowings
• Offshore BankDeposits
Expansion to Bond Purchases Raises More Questions than Answers:
• Price sensitivity of sellers
• Potential sellers considering price sensitivity
• Voters realize this is debt transfer/subsidization
• Direct issuance an ever clearer signal to voters
• Legal and ratings issues
• < € 440B available versus > € 3.2T periphery debt load (treasury level only)
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Advanced Economies’ Projected Path is Unsustainable
10
•Public debt has increased to unprecedented levels, rising from a postwar low of 34% in 1974 to a projected record high of 110%by YE2010•Unprecedented adjustments are required across the G-7•The status quo is not an option
General Government Net Debt Scenario Under 2010 Policies(In percent of GDP)
Source: IMF
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4%
6%
8%
10%
12%
14%
16%
02000400060008000100001200014000160001800020000220002400026000280003000032000340003600038000400004200044000460004800050000520005400056000580006000062000640006600068000700007200074000760007800080000820008400086000880009000092000940009600098000100000102000104000106000108000110000112000114000116000118000120000122000124000126000128000130000132000134000136000138000140000142000144000146000148000150000152000154000156000158000160000162000164000166000168000170000172000174000176000178000180000182000184000186000188000190000192000194000196000198000200000202000204000206000208000210000212000214000216000218000220000Greece IrelandJapan United StatesUnited Kingdom SpainPortugal FranceBelgium AustriaNetherlands
Unprecedented Fiscal Imbalance Creates Policy Conundrum
• Nearly a dozen countries require fiscaladjustments, representing approximately
54% of global GDP.
• Policies that promote near term economic
growth are mutually exclusive to policies
that are fiscally responsible.
• Policy choices are affected by election
cycles.
• This elevates monetary, fiscal and
regulatory policy risk to new levels, which
in turn affects economic growth prospects.
11
* Reflects fiscal adjustment needed to reduce a country’s debt/GDP2009 Gross domestic product in constant 2000 U.S. dollars Sources: IMF; WEO; WDI
Required Adjustment Betw
een 2010
and 2020 *
Indebted Countries’ Contribution to World GDP
Bubble size indicates magnitude of GDP contribution
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Die Deutsche Frage – A Difficult Balancing Act
12
European Banking Exposure to GIIPS nations (% of Common Tier 1 Capital)
Sources: BIS; SNL; Knight Research
0%
50%
100%
150%
200%
250%
300%
350%
0.5 0.7 0.9 1.1 1.3 1.5 1.7
Exposure to GIIPS
(% of Tier 1 Common
Capital)
Core ROA
German Banks
French Banks
U.K. Banks
Italian Banks
Spanish Banks
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March Madness - Political Risk Is High and Rising
• Funny thing about democracies is the feedback loop
between electorates and national policy
• Policy risk remains tethered to national, and even
regional political risk across the European Union
– Higher risk within coalition governments
– Breakdown of coalition (i.e. Ireland) can lead
to snap elections and uncertainty around
policy action
• Two primary sources of political risk as it relates to the
Euro sovereign crisis
– Stressed states (periphery Europe) lose the
electoral support to carry out reforms, trim
deficits, and curtail debt
– Core Europe or payer states (e.g. Germany)
lose electoral support to bail out Peripheral
Europe or debtor states
Eurozone Political Sound Bites:
“We believe that Ireland may be left with no option, in
the absence of a renegotiated deal, but to write down
the value of the bonds in the Irish banks or face the
prospect of a hugely damaging sovereign default”
Fine Gael, Irish Opposition Party, February 2, 2011
“62% of [German] voters oppose further bail -outs of
weak euro members….”
The Economist, January 13, 2010
“49% of Germans would like to have a return of the D
Mark”
YouGov Insitute, December 26, 2010
It may be “useful for the € 440 billion European
Financial Stability Facility to buy government bonds”
Jean-Claude Trichet, January 26, 2011
13
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March Madness – German Regional Elections Will SignalVoter Sentiment Toward Bailouts
•Spanish national election due in March
2012•13 autonomous regions hold
elections in 2011
•Greece national election due in 2013
•Portugal national election late 2013
•Italian national elections due in April 2013
•Early election could materialize in
Spring 2011
Image Courtesy of www.expansys-usa.com
•Irish national election on February 25,
2011 •First national election spawned by
crisis•Fine Gael positioned to form
coalition government with Labour
•Election one year ahead of
requirement
•German federal election in 2013
•7 regional elections in 2011•Four elections in February and
March•In 3 of those elections the CDU
(Angela Merkel’s party) is in the
ruling coalition
•Losses in the states will reduce the
ruling parties’ representation in the
Bundesrat, the upper house at thenational level
•French national election June 2012
14
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March Madness – Debt Maturities Heavily Loaded in March
15
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
J F M A M J J A S O N D
Sovereign Debt Financial Sector Debt
2011 Total Eurozone Monthly Debt Maturities: Sovereign and Financial (€, MMs)
Source: Bloomberg; Knight Research
- Irish National Election - German Regional Election
- 3 German Regional Elections
- German Regional Election - Spanish Regional Election - 2 German Regional Elections
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Risk Premiums
16
0
50
100
150
200
250
300
Feb-10 May-10 Aug-10 Nov-10
Italian Sovereign
UniCreditIntesa Sanpaolo0
50
100
150
200
250
300
350
400
Feb-10 May-10 Aug-10 Nov-10
Spanish Sovereign
SantanderBBVA
0
100
200
300
400
500600
700
800
900
1000
Feb-10 May-10 Aug-10 Nov-10
Poturguese Sovereign
Banco Espirito Santo
BCP
0
200
400
600
800
1000
1200
1400
Feb-10 May-10 Aug-10 Nov-10
Irish Sovereign
Bank of Ireland
AIB
Italian Sovereign vs. Financials (5Y CDS) Spanish Sovereign vs. Financials (5Y CDS)
Portuguese Sovereign vs. Financials (5Y CDS) Irish Sovereign vs. Financials (5Y CDS)
Source: Bloomberg; Knight Research
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Volatility in Non-Externally Supported Nations
17
French Sovereign/ CAC 40
Credit Agricole
Societe Generale
BNP Paribas
Standard Deviations
German Sovereign/ DAX
Deutsche Bank
Commerz Bank
Standard Deviations
U.K. Sovereign/ FTSE 100
Barclays
Lloyds
Standard Chartered
HSBC
Standard Deviations
Japanese Sovereign/ Nikkei-225
Sumitomo Mitsui
Nomura Holdings
Standard Deviations
U.S. (Deviations from 2Y Mean)
Bearish Bullish
3 2 1 0 1 2
U.K. (Deviations from 2Y Mean)
Bearish Bullish
Japan (Deviations from 2Y Mean)
Bearish Bullish
France (Deviations from 2Y Mean)
Bearish Bullish
Germany (Deviations from 2Y Mean)
Bearish Bullish
3 2 1 0 1 2 3
3 2 1 0 1 2 33 2 1 0
3 2 1 0 1
U.S. Sovereign/ S&P 500
Bank of America
Citigroup
JPMorgan
Wells Fargo
KBW Bank Index
Standard Deviations
Equity
CDS
Source: Bloomberg; Knight Research
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Volatility in Externally Supported Nations
18
Italian Sovereign/ FTSE MIB
UniCredit
Intesa Sanpaolo
Standard Deviations
EquityCDS
Spanish Sovereign/ IBEX 35
Santander
BBVA
Standard DeviationsEquity
CDS
Portuguese Sovereign/ PSI-20
Banco Espirito Santo
BCP
Standard Deviations
Equity
CDS
Irish Sovereign/ ISEQ
Bank of Ireland
AIB
Standard DeviationsEquity
CDS
Portugal (Deviations from 2Y Mean)
Bearish Bullish
3 2 1 0 1 2 3
3 2 1 0 1 2 3
Italy (Deviations from 2Y Mean)
Bearish Bullish
Spain (Deviations from 2Y Mean)
Bearish Bullish
Ireland (Deviations from 2Y Mean)
Bearish Bullish
3 2 1 0
3 2 1
Source: Bloomberg; Knight Research
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Total Divergence
19
Equity/ CDS Differential by Standard Deviation (2Y Mean Basis)
Source: Bloomberg; Knight Research 0 0.5 1 1.5 2 2.5 3
Sumitomo MitsuiBank of America
Deutsche BankStandard Chartered
BarclaysJPMorgan
CitigroupBanco Espirito Santo
BCPWells FargoHSBC
Credit AgricoleBBVA
Nomura HoldingsUniCredit
LloydsSantander
BNP ParibasIntesa SanpaoloBank of Ireland
Societe GeneraleAIB
Commerz Bank
U.K. Sovereign/ FTSE 100Spanish Sovereign/ IBEX 35Italian Sovereign/ FTSE MIB
Japanese Sovereign/ Nikkei-225Portuguese Sovereign/ PSI-20
Irish Sovereign/ ISEQFrench Sovereign/ CAC 40
German Sovereign/ DAX
U.S. Sovereign/ S&P 500
Sovereigns/
Equity Market
Index
Banks
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Key Takeaways
• Primary catalytic events revolve around two key themes
– Slippage on fiscal reform in the GIIPS
– Popular (read voter) revolt in both the adjusting countries (e.g. GIIPS) and/or the
paying countries (e.g. Germany)
• Volatility should remain a defining market characteristic in the coming yearas policy action attempts to simultaneously address
– A sluggish economic recovery
– High unemployment
– Record levels of fiscal imbalance
20
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Notes
• Notes to Slide 10, “Advanced Economies’ Projected Path is Unsustainable”: Weighted average by PPP-
GDP. The debt scenario assumes that the cyclically adjusted primary balance, corrected for fiscal
stimulus measures, remains constant at the 2010 level (in percent of GDP). Nominal GDP is assumed
to grow by 3 percent per year. The interest rate–growth differential (r-g) is assumed to equal zero until
2014 and 1 percentage point afterwards. Moreover, the scenario accounts for the estimated increase in
aging-related spending.
• Note to Slide 11, “Unprecedented Fiscal Imbalance Creates Policy Conundrum”: Countries included
need at least a 5% change in fiscal policy to bring debt/GDP to 60%. Diagram excludes Cyprus, which
also requires a fiscal adjustment greater than 5% of GDP.
21
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Acknowledgements
• Slide 10, “Advanced Economies’ Projected Path is Unsustainable”: Graph entitled “General Government Net
Debt Scenario Under 2010 Policies” from IMF Staff Position Note: “Long-Term Trends in Public Finances in the
G-7 Economies” by Carlo Cottarelli and Andrea Scheachter, September 2010.
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Appendix A: Disclosures
Data as of February 4, 2011
DISCLOSURE STATEMENT: This information and opinions in this report have been prepared by Knight Capital Americas, L.P. and may be distributed by
Knight Capital Americas, L.P. or its affiliates (collectively, “Knight”). Any recommendation contained in this report may not be suitable for all investors.Moreover, although the information contained herein has been obtained from sources believed to be reliable, its accuracy and completeness cannot be
guaranteed. Knight has no obligation to tell you when opinions or information in the report change.
Analyst Certification
I, Brian Yelvington, hereby certify that (1) the views expressed in this report accurately reflect our personal views about the subject issuers and the
securities of those issuers and (2) that no compensation, direct or indirect, is related to providing a specific recommendation or view in this report.
I, Charles Mounts, hereby certify that (1) the views expressed in this report accurately reflect our personal views about the subject issuers and the
securities of those issuers and (2) that no compensation, direct or indirect, is related to providing a specific recommendation or view in this report.
Important Disclosures
Knight prohibits research analysts and members of their households from owning securities of any company of the analyst’s area of co verage. Knight
permits its research analysts and members of their households to own diversified mutual funds or exchange traded funds that may include companies
in a sector that the analysts covers.
Knight prohibits any research analyst from serving as an officer, director or advisory board member of any publicly traded company.
Analysts Compensation: The research analyst responsible for the preparation of this report receive compensation based on various factors, including
total revenue of Knight, a portion of which is generated by investment banking business. They do not receive compensation from any specific
investment banking transaction.
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Appendix A: Disclosures (cont’d)
Knight Research Disclosure for United Kingdom and European Union
This report is approved for distribution in any European Union jurisdiction by Knight Capital Europe Limited (KCEL) and is only suitable for an investment
firm or investment professional . KCEL does not itself act as a market maker in any of the securities discussed in this report. Research analystsemployed by Knight Capital Americas, L.P. who wrote or who were involved in writing this report are not compensated by KCEL.
Knight Capital Europe Limited is Authorised and Regulated by the Financial Services Authority and a member of the London Stock Exchange.
Registered Address: City Place House, 55 Basinghall Street, London, EC2V 5DU United Kingdom.
Other Disclosures
This “Catalyst Calendar: a Sovereign Roadmap” is asof February 7, 2011.
This research presentation was prepared for the institutional clients of Knight. This presentation was not prepared for any individual client or prospective
client of Knight. At any time, employees of Knight may hold opinions that differ from those in this research report, based upon their independent review
of the issuer or securities that are the subject of this research report. Knight regularly trades in and regularly holds long or short inventory in thesecurities discussed in this research report. The positions held can be inconsistent with the technical opinions or recommendations outlined in this
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Securities mentioned, recommended, offered, or sold by Knight or its affiliates are not insured by the Federal Deposit Insurance Corporation and are
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Additional information is available upon request.
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