Across_the_Curve_in_Rates_and_Structured_Products_and_Across_the_Grade_in_Credit_Products--December...

8/22/2019 Across_the_Curve_in_Rates_and_Structured_Products_and_Across_the_Grade_in_Credit_Products--December 19, 200

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Please see Regulation AC certification and other disclaimers on the last page of this document.

December 19, 2006

Bear, Stearns & Co. Inc.383 Madison Avenue

New York, New York 10179

(212) 272-2000www.bearstearns.com

Coordinators:Steven Abrahams, Rates Markets

Gyan Sinha, Credit Markets

Victor Consoli, Corporate Credit Markets

EconomicsJohn Ryding (212) 272-4221

Conrad DeQuadros (212) 272-4026

Elena Volovelsky (212) 272-4447

Meghna Mittal (212) 272-1961

Treasuries/Futures/AgenciesDavid Boberski (212) 272-1507

Interest Rate Swaps/OptionsDavid Boberski (212) 272-1507

Jon Blumenfeld (212) 272-2993

Agency MBSSteven Abrahams (212) 272-2206

Victor Gao (212) 272-3082

Adjustable Rate MBSGyan Sinha (212) 272-9858

Aditya Bhandari (212) 272-1490

ABS and Non-Agency MBSGyan Sinha (212) 272-9858

Karan PS Chabba (212) 272-1978

Mary Ann Thomas (212) 272-7431

Aditya Bhandari (212) 272-1490

Jesse Singh, CFA

Beau Paulk (212) 272-2152

Kunal Shah

CDOsGyan Sinha (212) 272-9858

Karan PS Chabba (212) 272-1978

Andrew Bierbryer (212) 272-7331

Kunal Shah

CMBSMarielle Jan de Beur (212) 272-1679

Naynika Chaubey (212) 272-0894

Prepayments

Dale Westhoff (212) 272-2662V.S. Srinivasan (212) 272-8054

Steven Bergantino (212) 272-8234

Corporate Credit StrategyVictor Consoli (212) 272-5944

Michael Mutti (212) 272-5349

Emerging Market SovereignsCarl Ross (212) 272-9040

Outlook 2007

Rates: The Resilient Rates Market......................................................................3The Fed and foreign investors continue to have a firm grip on the U.S. rates

markets, although the road ahead looks rougher than last years stretch.

Corporate Credit Strategy: Good, But Not Great, Outlook for CorporateCredit in 2007....................................................................................................8Another year of solid credit fundamentals and technicals holding spreads in a tight

range. Active credit selection in our recommended sectors could provide further

upside from our expected return ranges of 4% in high grade and 6.5% in high yield.

Emerging Market Sovereigns: Emerging Market Debt: 2007 Outlook...........13For 2007, we believe spreads in emerging markets can continue to grind tighter,

though at a reduced pace. Our base-case scenario calls for a total return of

8%-10% on the index in 2007.

Rate Sectors

Economics .........................................................................................................17

Growth, Inflation and Monetary Policy Outlook for 2007

Treasuries/Agencies .........................................................................................21

Repo Scrutiny, Steeper Curve and a New GSE RegulationInterest Rate Swaps/Options ...........................................................................25

Swap Spreads in 2007: Grinding Tighter Volatility in 2007: Watching the Fed

Agency MBS......................................................................................................31

MBS in 2007: The Case for Tighter SpreadsAdjustable Rate Mortgages .............................................................................36

Agency Hybrid Outlook 2007Credit Sectors

Structured Credit .............................................................................................38

The Structured Credit Markets in 2007: Opportunities and ChallengesCMBS ................................................................................................................50

CMBS: A Year of FirstsPortfolio Strategies

Challenges and Opportunities in 2007 ..................................................55

ACROSS THE CURVEi n R a t e s a n d S t r u c t u r e d P r o d u c t s

AND

ACROSS THE GRADEi n C r e d i t P r o d u c t s


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Across the Curve and Across the Grade: Outlook 2007 December 19, 2006

2 Bear, Stearns & Co. Inc

View Across the Curve

The Spread Surface (as of 12/15/06)

Aver age Li fe Bucket

2 Y 3 Y 4 Y 5 Y 7 Y 10 Y

Average Life Spread to LIBOR 42 68Par Coupon Agency1

Cashflow / ZV Spread to LIBOR 33 56OAS to LIBOR -15 -10

Pricing Spread to Tsy 100 136Non-Agency Jumbo2Nominal Spread to Tsy 99 135

Cashflow / ZV Spread to LIBOR 52 84

OAS to LIBOR 16 20

Pricing Spread to Tsy 140Non-Agency Alt-A2Nominal Spread to Tsy 145

Cashflow / ZV Spread to LIBOR 92

MBS Pass-

Throughs

OAS to LIBOR 46

Average Life Spread to Tsy 87 118 125 131Current Coupon PAC9ZV Spread to Swap 44 75 77 77OAS to Swap -12 0 -2 0

StructuredMBS

OAS Spread to Collateral 2 14 14 16

Z Spread to Tsy (15 CPB) 46 62 77Agency Hybrid 3 Z Spread to Tsy (EPM)8 77 83 95

Cashflow / ZV Spread to LIBOR 37 41 45

OAS to LIBOR 26 19 19

Swap Spread (25 CPB) 20 45 60 80Non-Agency Hybrid4Swap Spread (EPM)8 47 54 79 94

Cashflow / ZV Spread to LIBOR 50 59 69 86

ARMs

OAS to LIBOR 39 38 35 42

Spread to Swap 2 4Aut os - Pr imeE-Spread 1 3

Credit Cards - Floating Spread to LIBOR -1 0 2 3 3 5

Spread to Swap (23 HEP) 35 45 55 75 90 100Home Equity - FixedNominal Spread (EPM)8 18 32 69 96

Cashflow / ZV Spread to LIBOR 21 32 67 95

OAS to LIBOR 16 23 51 73

Spread to LIBOR (23 HEP) 11 16 19 23 24HEL / HELOC FloatingNominal Spread to LIBOR (EPM)8 16 30

Cashflow / ZV Spread to LIBOR 16 31

ABS

OAS to LIBOR 16 31

Spread to Swap 17 21 30 24CMBS New Issue5E-Spread 17 21 30 24

CLO 24

ABS CDO 31CDOs

Trust Preferred

Spread to 3 mo LIBOR

32

Government Yield 4.725 4.567 4.595

Swap Yield 5.068 4.980 5.068

Agency Debt6 Yield 4.984 4.826 4.899

Corporate - High Grade7 OAS to Treasury 47 69 85 93 125

Corporate - High Yield7 Yield to Worst Spread 287 351 334

(1) FNMA 15 yr (5.41 cpn) AL spread to LIBOR @ 5 yr; FNMA 30 yr (5.38 cpn) AL spread to LIBOR @ 7.5 yr(2) 'AAA' shown for (from left to right) 15 yr (5.5 cpn) and 30 yr Jumbo (6.0 cpn) and (next row) 30 yr Alt-A (6.25 cpn)(3) Bonds shown from left to right are 3/1 (5.25 cpn), 5/1 (5.25 cpn), and 7/1 (5.5 cpn)(4) Run to Maturity; bonds shown from left to right are 3/1 (5.5 cpn), 5/1 (5.5 cpn), 7/1 (5.75 cpn), and 10/1 (6.0 cpn)(5) 5 yr bond is tight window; 10 yr bond is 30 % super senior(6) Agency spreads are FNMA debt(7) Corporate Index spreads for the following maturities: HG: 1-3 yr, 3-5 yr, 5-7 yr, 7-10 yr, 10-50 yr; HY: 1-5 yr, 5-10 yr, 10+ yr; HY bonds are callable(8) EPM is Econometric Prepayment Model(9) Spread of 6.0% PAC structured off of 30-year Freddie Mac TBA collateral.

For historical spreads, go to Relative Value Studio:https://aloha.bearstearns.com/rvs/rvMain.jsp.Contact your sales representative if you do not have access.
https://aloha.bearstearns.com/rvs/rvMain.jsphttps://aloha.bearstearns.com/rvs/rvMain.jsp


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December 19, 2006 Across the Curve and Across the Grade: Outlook 2007

Bear, Stearns & Co. Inc. 3

Strategy Outlook for theEnd of 2007

Fed funds: 5.25% 25 bp2-Yr Treasury: 5.00% 25 bp

View Across the Curve: Rates

The Resilient Rates MarketSteven Abrahams (212) 272-2206 / [email protected]

The Fed and foreign investors continue to have a firm grip on

the U.S. rates markets, although the road ahead looks rougherthan last years stretch. The Fed faces a contentious battlewith market expectations over the path of policy, withwidespread doubt about the Feds willingness and ability toavoid a rate cut. A steady Fed should prevail. Foreigninvestment in U.S. debt should again keep long-term rates wellbelow levels indicated by economics alone, but flows shouldlighten as the cost of servicing U.S. foreign debt continues torise. The yield curve looks likely to rise modestly fromcurrent levels and remain inverted with volatility generallylower and spreads tighter at least through the first half of theyear. For investors, the payoffs should come in a few ways:

By remaining either barbelled around target durations oroverweighted in cash

By taking spread risk in the first half of the year, and By selling options in the first half as wellDespite prospects for a bumpier road, the rates markets stillcan rely on persistent global liquidity to help absorb mostshocks. The road may get a little rougher, but the marketlooks resilient.

Rates and the Fed

The Fed in 2007 is likelyto find itself in acontinuing fight with themarket over expectationsabout policy, with most ofthe impact coming on theshort end of the Treasurycurve. Taken at face value, everything the Fed says suggeststhat through most of next year it expects to keep fed funds atleast at 5.25%. The market, however, doubts that. Thats themessage implied by 2-year Treasury yields that have traded aslow as 4.50% in recent weeks and now stand near 4.70%. TheFed and the markets are at loggerheads. For 2007, my moneyis on the Fed.

The Fed has a clear comparative advantage in this forecastinggame. It certainly has as much economic information asanyone. It has as large and as competent a staff of analysts.But unlike most other players, it has incentives to get the pathof inflation and growth right and no way to diversify away itsrisk of being wrong. Fed transparency has upped the ante,with the institutions credibility riding partly on its forecasts ofthe economy. Information, expertise and incentives are apowerful combination. If the Fed saysas it has repeatedly

latelythat foreseeable economic conditions justify steady

policy, that view deserves significant weight. Its economiccall through 2006, after all, has been excellent.

The market does have grounds for believing that the Fed couldbe wrong and that the economy could force the Fed to ease. In1989, 1994, 1998 and most recently in 2000 the market drove2-year Treasury yields well below fed funds in expectation ofan eventual ease. In each case, the Fed did eventually easeThe Fed is fallible.

Nevertheless, John Ryding and his team make an excellencase that the Fed will not see its hand forced in 2007 (seeParallels with 2000, Across the Curve, December 5, 2006)Consumer balance sheets remain strong, with gains in housing

over recent years leaving net worth near record levels despitesoftening home prices. Corporate balance sheets remainstrong, too, with near record levels of cash. These signal amuch stronger economy than the one faced by the Fed in2000, for instance, after the bursting internet bubble drewdown consumer wealth and eventually trimmed capitainvestment. In fact, Ryding thinks the strong economy wilforce two hikes in 2007, with funds ending at 5.75%.

Market expectations for inflation also point to a Fed at least onhold. The single most effective variable for gauging Fedpolicy has been the spread between 10-year Treasury notesand TIPS.* When that spread falls materially below 200 bp

the Fed tends to ease. When it rises materially above, the Fedtends to tighten. Today that spread stands near 230 bpnoenough to spur the Fed higher, but far from enough to signalan ease (Figure 1). Only if the spread dipped toward 150 bpand stayed there long enough to constitute a reliable signamight the Fed lower rates. Unlikely.

* Sack, Brian (2003). A Monetary Policy Rule Based on Nominal andInflation-Indexed Treasury Yields, Finance and Economics DiscussionSeries Working Paper No. 2003-7, Board of Governors of the FederalReserve System.


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10-Year Treasury: 4.85% 25 bp

Figure 1. Inflation Expectations: Unlikely to Signal a Fed Easein 2007

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40

2.60

2.80

3.00

12/18

/2003

3/9/20

04

5/28/2

004

8/18/2

004

11/8/2004

1/27/2

005

4/19/2

005

7/8/20

05

9/28/2

005

12/19

/2005

3/10/2

006

5/31/2006

8/21/2006

11/9/2006

Imp'dInfla:10YNote

s-10YTIPS(%)

Biased to Ease

Biased to Tighten

Source: Bear Stearns

Investors in the short end of the U.S. curve should also worryabout the path of the European Central Bank. Many analysts

see the ECB pushing up euro policy by the end of 2007.Given the good odds of depreciation in the dollar against theeuro, any narrowing of the interest rate difference betweenU.S. and euro rates should encourage flows out of the U.S andinto euro, especially for foreign private portfolios not weddedto managing exchange rates. Central banks are another story.

The likely tension between the Fed path and a marketanticipating an ease should drag yields along the short end ofthe Treasury curve higherwith a little kicking and screamingalong the way. Yields on 2-year Treasuries should end upcloser to 5.00% than where they stand today. And the realizedvolatility of short rates should rise from levels seen in 2006.

Rates and Global Flows

In 2007, the globalstampede of dollars intoU.S. debt may slow,paving the way for amodest and sustained risein 10-year yields into theneighborhood of 4.85% or higher. Foreign investment shouldstill keep yields on the long rates well below levels dictated byeconomics alone. At times, foreign flows in recent yearsequivalent to more than 7% of GDP have dragged 10-yearyields as much as 95 bp below the levels that economics alone

might anticipate.+

Those flows will not turn on a dime, butthey may have good reason to throttle back.

Foreign inflows have dominated the long end of the curve asthe U.S. current account deficit has exploded. The U.S.

+ Warnock, F.E. and V.C. Warnock (2005) International Capital Flows andU.S. Interest Rates, International Finance Discussion Series WorkingPaper No. 2005-840, Board of Governors of the Federal Reserve System.

simply buys more than it produces, and it borrows thedifference by selling bonds. The persistence of the deficistands on several grounds.

Currency policy. China and other Asian exporters linktheir currencies to the dollar in order to remain the low-cost providers to the U.S. and other dollar-bloc markets

That forces these exporters to buy dollars in order toprevent appreciation of their local currencysomethingthat would push up the price of their exports in dollarterms. These countries have taken their resultingimmense foreign reserves and plowed two-thirds of themright back into U.S. debt. The arrangement has helpedboth sides: the exporters effectively buy access to the U.Smarkets, and the U.S. gets inexpensive money.

The international role of the dollar. The dollars role ininternational trade has created powerful constituencies forkeeping other currencies pegged to the greenbackAmong central banks, an estimated 66% of the worlds$4.8 trillion in reserves sit in dollar assets, a powerfuincentive to preserve the dollars value. In addition, asignificant percent of international trade outside ofEurope gets priced and settled in dollars even in theabsence of a U.S. counterparty, an incentive to avoid thefriction of currency volatility.

The relative quality of U.S. debt markets. In sizeliquidity and diversity, the U.S. debt markets have sizableadvantages over other places where global investorsmight put their funds. At the end of 2005, for instancethe U.S. had $22 trillion in non-government deboutstanding compared to $10 trillion in euro, $2.5 trillionin yen and $1.5 trillion in sterling. U.S. debt also spanned

a wider range of rating categories and includedsignificantly more securitized assets than the other

markets. Apart from individual credit concerns, theability to diversify constitutes another source of safety inU.S. debt.

None of these factors change quickly, but on the last countthe relative quality of U.S. debtthe tide may turn a little in2007, and not so much in the eyes of central bankers as in theview of foreign private investors. Those investors might starto worry that the U.S. is approaching practical limits toexpanding its foreign liabilities.

Until just this year, the U.S. was able to cover the costs of itsballooning foreign liabilities simply out of the cash flow fromits own foreign investments (Figure 2). In 2005, for examplethe U.S. received from foreign assets $17.5 billion more thanit paid out for foreign liabilities. Considering the nearly $6trillion in current account deficits piled up over the last quarter

Galati, G. and P. Wooldridge (2006) The Euro as a Reserve Currency: AChallenge to the Preeminence of the U.S. Dollar? Bank for InternationalSettlements Working Paper No. 218.


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1Y10Y SwaptionVolatility: 80 bp 5 bp

5Y5Y SwaptionVolatility: 80 bp 5 bp

century, the surplus is remarkable. Some analysts have arguedthat this persistent surplus signals that the current account

deficit is easily sustainable. Through the first half of 2006,however, revenues from foreign assets fell short by anannualized $7 billionthe first shortfall in at least 46 years.With the maturing of U.S. debt issued in 2002-2004 and itslikely reinstatement at todays higher rates, the U.S. shortfall

looks bound to grow.

Figure 2. Covering the Cost of U.S. Foreign Liabilities GetsHarder

-$10

$0

$10

$20

$30

$40

$50

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

USNetInt'lInvestInc($B)

Source: Bureau of Economic Analysis

The U.S. and its lenders consequently find themselves like ahomeowner and banker watching the borrowers thinningability to cover mortgage costs. The investment account usedto do it. Now the homeowner has to reach into other pockets.And the payment is going up. That could take a little of thefizz out of the economic party. No lender likes that.

Any nervousness about the increasing burden of servicing

U.S. foreign liabilities is likely to show up first in the flows offoreign private investors. Without a currency to protect,private investors have more leeway than central banks do tosell. Private investors also face improving conditions in otherglobal markets. The pool of foreign currency reserves hasmade a number of emerging markets countries much safertoday than they were five years ago, something reflected inthis years generally tighter spreads. The prospects forappreciation in the euro against the dollar could also drawfunds into Europe. Nervousness among foreign investorswould show up in higher U.S. rates.

From January through March 2006, we saw the impact of adrop in foreign inflows into U.S. debt. Foreign investorsbought $82 billion fewer Treasuries than they did the yearbeforealthough foreign portfolios instead invested heavilyin spread productsand real yields in the U.S. rose by 35 bp.The year ahead is likely to see more episodes like this.

See Ricardo, R. and F. Sturzenegger (2006). Why the U.S. CurrentAccount Deficit is Sustainable,International Finance, 9 (2), 223-240. Fora contrasting view, see Gros, Daniel (2006). Why the U.S. CurrentAccount Deficit is Not Sustainable,International Finance, 9 (2), 241-260.

Foreign investors look likely to cut back their appetite forTreasury debt and raise it for spread product as a way todiversify risk.

Before leaving a discussion of the curve, its worth noting thatstudents of U.S. business cycles see good reasons to believethat the yield curve could steepen next year instead of

remaining inverted. An important part of this case rests onexpectations for weaker credit. David Boberski lays out a casefor a steeper curve in Repo Scrutiny, Steeper Curve and aNew GSE Regulation in these pages. Im still staked to thebet that this cycle will continue to be a little different.

The Volatility Markets

The Fed, issuance of bankdebt and possibly themortgage market shouldshape the path of impliedvolatility in the year aheadwith volatility rising over

2006 levels in shorteroptions while falling inlonger ones. The shape ofthe volatility surface maychange, but the general level still shouldnt stray too far fromthe levels of this year, which were some of the lowest sincethe 1960s.

The main source of volatility in short-dated options shouldcome from the likely tension between the Feds actual pathand the markets eagerness to anticipate an ease. The pricingof the 2- to 5-year part of the curve today embeds a bet thathe Fed will ease. If they do, these notes will have enough

duration to profit from the likely ensuing rally. If theeconomy instead produces acceptable inflation and growth, asthe Fed anticipates, then front of the yield curve will need tore-price. Look for the re-pricing. And look for volatility inthe short part of the curve to rise.

The volatility implied by long-dated options should drift lowerthrough the first quarter as the refinancing of callable banktrust preferred debt continues. Nearly $25 billion of the debissued in 1996-1997 and in 2001-2002 becomes callable in awindow running from December through March. Much othis is likely to get refinanced into new callable debt and thenswapped, leaving the Street heavy with supply of long-datedoptions. Mortgage investors should absorb some of the

supply, but slowly. Look for volatility in long-dated optionsto bottom in the second quarter as the trust preferred pipelineempties.

The joint effect of rising volatility in short-dated options andfalling volatility in long-dated should reshape the volatilitysurface; short-dated vol should rise relative to long-datedThats most likely to happen in the first half of the comingyear. By the second half, demand for long-dated options fromthe mortgage market should put a floor on the trend.


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2-Year Swap Spread:30 bp 2.5 bp

10-Year Swap Spread:40 bp 2.5 bp

As for the mortgage market, it should add to net demand foroptions by continuing to add to the stock of 30-year loansoutstanding near par. In the first half of 2006, the general risein rates left most mortgages below par, reducing the need forservicers and others to manage negative convexity.Nevertheless, more than $950 billion in new fixed-rate loanswere produced around par last year, and in the year ahead

another $830 billion should roll out of the pipeline. Prudentservicers will buy some option protection on all of thatproduction. Of course, if 10-year Treasury yields take asurprising sustained dip below 4.35%, then the rising negativeconvexity of the mortgage market should drive up demand foroptions sharply.

Jon Blumenfeld and David Boberskis detailed outlook for thevolatility markets appears elsewhere in these pages inVolatility in 2007: Watching the Fed.

The Spread Markets

Opinions on spreads

around here vary fromslightly wider to slightlytighterusually with theoutlook for creditbutIm in the tighter camp.Spreads in swaps, agencyMBS and agency debtlook likely to end thecoming year tighter than where they began. The keyassumptions Im making: that credit spreads will generallytighten and that MBS will avoid a refinancing wave.

Swap spreads in the last year moved largely in sync with

spreads in credit while other potentially important drivers ofswap spreadsmortgage hedging, Treasury repo, debt

issuance and Treasury supplylargely sat on the sidelines.In fact, tightening credit spreads and an inverted Treasurycurve helped invert the 2- to 10-year swap curve in Februaryand then again in November and December. As long as MBSavoids a refinancing wave, credit should still call the tune forswaps.

While credit always has a few surprises in storeemergingmarkets, leveraged buy-outs and subprime housing providedsome in 2006a generally healthy global economy andcontinuing diversification of global dollar portfolios awayfrom basic Treasury and agency debt should help spreads.

The World Bank sees global GDP rising by 4.9% next year,which would cap the strongest 4-year stretch of growth sincethe early 1970s.

For a detailed discussion of these factors, see Kobor, A., L. Shi and I.Zelenko (2005). What Determines U.S. Swap Spreads, World BankWorking Paper No. 62.

The U.S. Treasurys TICS data continue to signal sizablediversification of global dollar portfolios into spread productsas does the World Banks latest Global Financial StabilityReport. The diversification makes sense for global investorstrying to protect against the rising cost of U.S. debt service ordepreciation in the dollar. Global growth and dollar portfoliodiversification should keep the appetite for spread product

very healthy.

With swap spreads likely to tighten and key parts of thevolatility surface likely to fall, mortgage spreads shouldtighten too, especially in the first half of next year. Goodforeign demand for MBS should continue, with most of thacoming from foreign central banks. MBS should also seereasonable demand from U.S. banks as well since it is one ofthe few remaining rates products with positive carry to shortterm funding; U.S. banks also should reach for MBS next yearas a slowing economy trims demand for business andconsumer loans. Demand from GSEs is likely to fall belowthe expected 7% growth rate in outstanding 1-4 familymortgage debt, but the GSEs have not been key marginabuyers of MBS since 2001. Nominal spreads of MBS toTreasuries and swaps should slowly tighten as long-datedvolatility drops in the first half of next year; nominal spreadsin the second half should soften. Good demand should keepOAS tightening all year long.

Finally, spreads in agency debt stand to end the year tighter tothe Treasury curve. The stock of outstanding agency debshould follow the slight growth in portfolio balances, butdemand from foreign portfolios remains robust. With manyinvestors expecting few opportunities for trading profits, thespread in agency debt should prove attractive.

Views on the swap and agency MBS markets are detailedelsewhere in these pages in Swap Spreads in 2007: GrindingTighter and in MBS in 2007: The Case for Tighter Spreads.

Still Riding Down Liquidity Lane

Despite concerns about a modest rise in Treasury rates, apersistent inversion in the curve, some twists in volatility andexpectations for tighter spreads in most markets, U.S. ratesstill can rely on a historically deep supply of liquidity. Mosof the changes anticipated in 2007 reflect subtle shifts in thatliquidity. The higher rates could come with rising concernabout the cost of U.S. foreign liabilities, the tighter spreadswith continuing diversification. But the liquidity should stil

allow the market to absorb change easily. The ongoingproliferation of hedge funds and growth of assets undermanagement helps, too, bringing investors willing to be eitherlong or short into an increasing number of markets. Liquidityand its managers should continue to be forces in 2007 for wellfunctioning markets.


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If this outlook gets derailed, its likely to be at the instigationof only a few things:

Recession in the U.S. A U.S. recession would havedramatic implications for both rates and spreads. In rates,recession could spur a sharp steepening of the yield curvewith a both a quick drop in short-term rates and a modest

rise in long-term rates. The drop in short-term rateswould reflect broad expectations of a series of cuts by theFed. The rise in long-term rates would reflectexpectations of a shrinking U.S. current account deficitand less foreign reinvestmentas consumer spendingslowed. Recession would normally dictate a drop in long-term rates, but shifting foreign demand would likely makethis yet another exception to long-standing rate marketrules. In spreads, the prospects of recession would raiseconcerns about credit and send spreads in swaps and MBSwider.

Politics in China or the U.S. The benefits of the currenarrangement between Chinas exporters and U.Sborrowers dont extend to everyone in those countriesand politics could reflect any discontent. The tension inChina is between the wealthy coastal areas that are hometo most exporters and the poorer interior regions. In theU.S., it is between service industries that benefit from

globalization and manufacturers that dont. Chinasinterior could demand an end to purchases of dollarssomething that effectively subsidizes the export sectorand a beginning to investment in interior infrastructuresuch as health care, social security and pensions. In theU.S., theres already pressure to break Chinas link to thedollar through tariffs or other means. These kinds opolitics in China or the U.S. would send long-term ratesmuch higher.

Beyond these or other unforeseen risks, a flat or inverted yieldcurve with modest moves in rates and tighter spreads seem inthe cards for 2007 and possibly beyond.


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View Across the Grade: Corporate Credit Strategy

Good, But Not Great, Outlook for Corporate Credit in 2007Victor Consoli (212) 272-5944 / [email protected]

We expect the continued strong technicals from synthetic

instruments and investor liquidity to remain, holding spreadsin tight range, and we view the economy as very supportivefor another year of solid credit fundamentals, with Treasuryrates being the major swing factor to our outlook.

Most of the elements of a good corporate credit environmentshould remain in place throughout 2007, allowing for highgrade returns in the 4% range and high yield returns in the6.5% range, falling behind the respective 4.7% and 11% highgrade and high yield returns for 2006. The outlook for theTreasury market is perhaps the most significant swing factor,with the Street consensus on rates ranging more than 100 bps,implying a 56 percentage point variance of potential returns.We have at least contained our scenarios to the camp ofgradually rising rates, somewhat narrowing the potentialimpact on our forecasts to 12 percentage points of variance.We recommend amarketweight in corporate credit overall for2007, with the direction of rates being the key to furtherupside.

Marketweight high grade. High grade can expect to besubjected to the see-saw of LBO speculation pushing spreadswider, particularly in CDS, and then having the spreadsquickly tighten as CDOs/CPDOs find high-nails to sell down.In cash, we expect growing demand from U.S. pensions andforeign buyers, particularly at the long end. The demand fornew issuance should remain strong, with more deals having

some covenant protections. The threat to high grade spreadsand total returns is that Treasury yields could gradually widenand LBOs or that other credit-dilutive shareholder-friendlyevents could collectively chip away 1.5 points of return froman average index coupon rate of 5.9%, leaving 4%4.5% ofnet return and spreads perhaps 5 bps wider by year-end. Webelieve that returns could be improved beyond our baselineindex estimate by increasing exposure to autos, energy,homebuilders, media/cable, supermarkets and telecom.

Marketweight high yield. In high yield, we expect the demandfor new issuance, particularly for well-sponsored LBOfinancings, to remain very strong. We think that the 11%returns in 2006 (9.5% excluding autos) will entice more retail

inflows into high yield mutual funds, and we expect the hedgefund strategy of leveraging leveraged loans and buying highyield bonds to remain attractive; spreads could tightenmarginally, into the range of 300330, through the secondquarter. In our view, the 8% average high yield coupon wouldbe the upper end of expected returns in 2007, partly becausethe contribution from autos, cable and telecom will be hard toreplicate. We see little risk of default rates increasingsignificantly and expect only a slight increase in defaults, tothe 2.3% range, largely on the seasoning of the substantial

triple-C issuance from 2004. Were mildly concerned tha

corporate profits could begin slowing later in 2007 and thathe expected supply of new issuance, particularly LBOfinancings, could come at an attractive price, which couldcause a bit of relative value pressure. While we think that thehigh yield market will have a strong start to the year and couldpossibly tighten through 300 for a test, we ultimately foreseehigh yield spreads backing out towards their 2006 mean of357 by year-end, leaving us with an expected high yield returnof about 6.5% for 2007. Lower Treasury rates or lowerdefaults can of course also improve returns, but more activelywe believe higher returns could potentially be achieved byincreasing holdings in the autos, cable, energy, homebuildersretailers and wireless sectors.

2007 Potential Return Outlook

High Grade Scenarios

4Q06

Spread 102 102 105 107 107

UST 10-year 4.6 4.6 4.7 4.8 5.1

Annual change (bps)

Spread 0 3 5 5UST 10-year 0 10 20 50

Returns attributable to:

Coupon 5.9 5.9 5.9 5.9

Spread 0.0 -0.2 -0.3 -0.3

UST 10-year 0.0 -0.6 -1.2 -3.0LBOs -0.3 -0.3 -0.3 -0.3

Expected Return (%) 5.6 4.8 4.1 2.3

High Yield Scenarios4Q06

Spread 330 315 330 350 360

UST 10-year 4.6 4.6 4.7 4.8 5.1

Defaults 1.8 2.3 2.3 2.3 2.3

Annual change (bps)

Spread -15 0 20 30

UST 10-year 0 10 20 50

Returns attributable to:

Coupon 8.0 8.0 8.0 8.0

Spread 0.8 0.0 -1.0 -1.5

UST 10-year 0.0 -0.5 -1.0 -2.6

Defaults -0.9 -0.9 -0.9 -0.9

Expected Return (%) 7.8 6.6 5.0 3.0

Source: Bear Stearns Credit Research.

Looking back. In our initial outlook last year, we were far tooconcerned about the consumer slowing down, the fate of theauto sector, the Fed tightening, and wage and cost inflationputting pressure on corporate profits. We expected a mid-3%high grade return and eventually arrived at a 6% estimate forhigh yield. We became much more bullish on the creditmarkets and homebuilders in later July, and for high yieldproposed barbelling double-Bs and triple-Cs and fadingsingle-Bs.


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Four legs support the credit platform. Overall, the economy,credit fundamentals, market technicals and investors viewsare now and should remain in a very beneficial position,permitting fairly good corporate credit returns.

Starting with the economy, we expect unemployment to holdat 4.5%, with wage growth over 4%, inflation remaining in the

mid-2% range, and real GDP growth in the area of 2.7%3%.In our view this would be a fine environment to keep theconsumer spending, ensure a soft landing in housing andmaintain solid corporate profit growth. Should the Fed hikerates one more time, we think that foreign investors wouldlikely be pleased by this inflation-fighting diligence, as well asby the strength of the U.S. economy, and would increase theirdollar investments. Should the Fed stay on hold or even cutrates, it should also be well received, as it is the path themarket anticipates.

Second, credit fundamentals are still strong, with record-highcorporate cash balances1 and corporate leverage increasingslightly, to 2.8x from 2.6x. We expect defaults to increase

only slightly from record lows. We also expect an increasingportion of high grade new issuance to have protectivecovenants like change-of-control puts, limitations on liens orcoupon step-ups.

Third, we think that technicals will be driven by syntheticstructures like CDOs and CPDOs as sellers of protection,while natural buyers of such protection, such as banks, aremoving on to LCDS, all of which may be creating an effectiveceiling on spreads. Should IG7 back up to 3637 from 34.5today, CPDOs could become sideline index sellers of 15 timestheir notional amount. We think that hedge funds and propdesks will remain firmly focused on technicals, trading credit

around LBO speculation. Liquidity is still plentiful, comingfrom banks, hedge funds, the emerging markets and fromrecycled trade surpluses in Asia. The M&A cycle shouldcontinue as long as the stock market stays fairly valued andrates stay range-bound. Banks are eager to lend, having fewalternatives due to the inverted yield curve. We also see apotential $250300 billion of increased demand for longer-dated bonds from pensions as a result of new legislation.2

Fourth, investors have not been rewarded for being short orbearish, nor have they been punished for accepting more creditrisk. Volatility generally has been very low for most of theyear, with only a third of the trading weeks having seen theVIX above 13 (roughly the 200-day moving average), giving

investors the confidence to stay invested. There could still beinvestors on the sidelines waiting for the Feds next move, orfor a widening in spreads, before taking on more credit risk.

1 Cash held by S&P 500 (non-financials) is approximately $750 billion.2 SeeAcross the Grade, November 7, 2006, The Pension Law Changes and

a Few More Thoughts on CPDOs.

Four Legs Support the Credit Platform

Economy / Macro Credit Fundamentals

Employment is strong (4.5% UE, 4% wages) Corporate profit growth slowing but stable

Inflation reasonable (TIPs 2.3%, PCE 2.4%) Defaults are below 2%

Fed is win-win-win (last hike, pause, cut) Covenants and step-up protections

Lot of dollar-vested trade partners Lot of balance sheet cash ($750 billion SPX)

Housing/consumer = Fed/ low UE LBOs and leveraging will continue

Technicals / Liquidity Investors' View

CDOs/CPDOs driving spreads tighter Volatility is extremely low

Pension rules and Asia demand for long end No punishment for risk taking

Less natural demand for protection Opportunity cost of being under-invested

Continued lending to fund M&A and LBOs Competing asset choices vs. 5% CD rates

Strategies to watch. In a tight-spread, low-volatility, lowdefault-risk credit environment with an inverted/flat yieldcurve, we expect more leverage to be employed by hedgefunds to generate double-digit net portfolio returns out of 6%8% corporate credit yields. The leverage could be in the formof margin loans, aggressive CDX index selling, structuredproducts or even permanent debt financing, such as hedgefunds issuing bonds. The uses of these leverage sources aretypically to buy LIBOR+275 leveraged loans or to new issuehigh yield bonds, or perhaps for CDS protection on an LBOcandidate. We anticipate that trading LBO speculation wilremain the dominant credit theme until there is some episodeof volatility. We like purchasing volatility cheaplysetting upsteepener trades on LBO candidates, for example, or buyingHiVol protection where we see more LBO risk and funding itby selling the XO crossover index where we think more evenrisk has been priced in.

In general, when carrying out duration-neutral (DVO1-neutralsteepeners we are willing to accept default risk and sell LBO

risk, so, for example, we would sell more 3-year CDS to fundbuying 5-year CDS (or 5s/7s, 5s/10s). This is consistent withour view that credit curves are biased to steepening. We thinkthat there are fewer natural buyers of short-dated defaulprotection in CDS, and in a low-default environment tradersare more comfortable accepting default risk (selling 35-yearCDS) to fund the payment of LBO speculation (buying CDS)We would also seek out high grade bond issues with changeof-control or step-up covenants. Such issues often trade aonly a 1525-bp premium to similar bonds without covenantsand such premiums can become considerably more valuable inthe event of an LBO speculation.


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Sectors in Focus

High Grade High Yield

Relative Value Opportuni ties Relative Value Opportuni ties

Autos Media/Cable Autos Homebuilders

Energy Supermarkets Energy Retailers

Homebuilders Telecom Cable Wireless

LBO-Resistant Defensive

E&P Financials Gaming Satellites

Utilities Railroads Healthcare Media/DirectoriesLBO / Event Risk Potential Cable Wireless

Consumer Products

Industrials RetailersMedia/Newspapers

Sectors in focus. We suspect that there will be plenty of pressadvising credit selection (and adverse selection of LBO risk)as the roadmap to Alpha-cityno surprise there. We do thinkthat the credit market has good technical momentum behind itand that fundamentals are good, and we expect investors to beon the hunt for excess spread. We believe that autos, energy,homebuilders, cable, media and telecom offer some of the bestrelative spreads for their ratings and have a lot of headline risk

behind them. With Ford and GM having addressed theirliquidity needs, their 200708 default risk is essentially a non-concern, in our view, making these credits core-holdingcandidates, if theyre not already. We think that energy is agood defensive sector, with low LBO risk; its downsidescenariotrading even with industrialshas alreadyhappened. Our high grade energy index now trades even withour industrial index at 117 bps, having been 14 bps inside atthe end of 2005. We like the risk-reward in homebuilders,figuring that the sector most likely holds its 2030-bp relativediscount to triple- and double-Bs and should gradually tightenas the sector stabilizes. On the downside, the homebuilding

sector is 2.5x3x leveraged, the ratings agencies have alreadymade their downgrades, and the homebuilders have few short-dated maturities which reduce potential default triggers if theeconomy really slows. We also consider media (particularlycable) at 145 bps and telecom at 135 bps (as measured by ourhigh grade index) to be among the most attractive sectors, withtheir strong fundamentals likely to persist. We are more

cautious on high grade retailers because of LBO risk andpotentially higher minimum wages. Along with retailers, wealso see more LBO risk in industrials, consumer non-durablesand newspapers and could see a slightly higher risk premiumbeing demanded. Should the economy slow, we also thinkthese sectors would be more challenged.

In high yield, we think that the recent LBO issues will remainfavored, particularly retailers. These credits have among thebest spreads, as well as larger issue sizes and good tradingliquidity. We believe that the market likes fresh dealsconcerned that default risk starts to increase significantly afterthree years. We think that high yield buyers will look to autosas a sector with the worst behind it, with attractive spreads andwith significant upside potential remaining. We also favorcable, satellite and wireless, which generally have improvingfundamentals and the potential to issue equity over the next 18months. As in high grade, we also like the high yieldhomebuilders. The health care sectordominated by HCAwhere our high yield health care index is trading at 380 bpsalso has a lot of headlines behind it, and results are stabilizingit is one of the least economically sensitive sectors. Mediaparticularly the directories, remains an attractive free cashflow story, and in general, media credits with divestible assetscould benefit from the strong M&A cycle.

Bear, Stearns High Grade Corporate Index 2006 Sector Trading Ranges as of 12/08/06

60

80

100

120

140

160

180

Banking

Basic

Mate

rials

CapG

oods

-Mfg

Consum

erCyc

Consum

erNo

n-Cyc

Energ

y

Financials

Finance

Co

Index

Industria

ls

Insura

nce

Media

RealEstat

e

Securities

Technolog

y

Telec

om

Transportatio

n

Utiliti

es

Liquid

Index

OAS

Current

12/31/2005


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Bear, Stearns High Yield Index (BSIX) 2006 Sector Trading Ranges as of 12/08/06

175

225

275

325

375

425

475

525

575

625

675

Comp

osite BB B

AutoMfg

Related

BasicM

aterials

CapGo

ods-Mfg

Consume

rCyc

ConsumerN

on-Cyc

Energ

y

Finance

Healthc

areMe

dia

Techn

ology

Telec

om

Transp

ortation

Utility

OAS

Current

12/31/2005

Where could market stress come from? Tight spreads leadmany of us to think that we are not being fairly compensatedfor risk, but the market establishes a price for everything, andwhen defaults are low, fundamentals are solid and the VIX isunder 13 more than two-thirds of the time, you could waitquite a while for the market to offer you better spreads. In thehigh grade index, spreads have actually widened to 102 from99, in part corresponding to the 10-year Treasury yield risingto 4.6% from 4.39% a year ago but maintaining the same 1.22corporate yield to Treasury yield risk premium (e.g., 4.6 + 102/ 4.6). Assuming that the UST 10-year yield moves up to the4.8%5.1% range from 4.6% today, if high grade creditorsremain content with a 22% spread premium, we could see highgrade spreads widen by 57 bps. The market could, of course,demand a greater spread premium to hold corporate risk ifinflation surges or if confidence corporate profits growthdiminishes.

We view any potential market stress as likely be episodic,coming from LBO speculation or from the inevitable string ofdown days in the stock market driven by earningsdisappointments or economic data. Recent episodicdisruptions have also been caused by unfortunate headlines

related to terrorism, hedge fund blow-ups and proposedregulatory changes. But these have all been short-liveddistractions, spiking volatility and widening spreads for daysto weeks only, and they are a reality of the markets. The largerriskslow probability, in our viewconcern the economystumbling or the market facing systemic problems like a dropin corporate profit growth, a cluster of defaults, or hedge fundscrowding into a mistaken theme.

Where Could Potential Market Stress Come From?

Economy / Macro Systemic Concerns

Housing hard landing (low probability) Corporate profit growth drops sharply

Inflation hits 3% (moderate probability) Multiple credit defaults (weak LBOs)

GDP below 2%, recession fears (low prob.) Hedge fund leverage problems

Severe dollar weakness (low prob.) Global liquidity stalls

Episodic Stresses Exogenous / Unpredictable

LBOs and rumors widen spreads Terrorism Tax hike rhetoric

Stock market corrections / VIX spikes Bird Flu Corporate fraud

Subprime mortgage contagion Oil shock New war or confrontation

Defensive positioning. Insurance comes at a cost, whetherfrom paying default protection premium or from forsakenopportunity. The least expensive defense, in our view, is toincrease a portfolios allocation to cash, shorten durationselect bonds with covenants, and overweight lower-viabilityLBO sectors like financials, railroads, utilities, deep-cyclicalscapital-intensive industries like E&P, and super-capcompanies (over $50 billion TEV). A more selective approachcould be to define a basket of LBO candidates and set up CDSsteepeners in each, funding these steepeners by selling the 5year XO7 CDX index (which, in our view, should demonstrate

less correlation to the VIX widening) or selling 3-year IG7 (or5-year IG4 with 3.5 years remaining), which can generatereturns just by rolling down the credit curve. Diversification isanother reasonable strategy: consider that there were onlyseven actual high grade LBOs in 2006, out of 700 issuersacross A3- through Baa3-rated high grade index credits(excluding financials and utilities). Albertsons, Kerr-McGeeand Knight-Ridder were close to being LBOs and ended upwith strategic acquirers. Overall, perhaps the best defensivestrategy is diversity and doing your credit homework, applied


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by swapping out of fully-priced high-LBO viability credits.Consider a diversified high grade credit portfolio of, say, 200names (0.5% positions): with six credits experiencing LBOwidening of 300 bps (15 bond points) and another ten LBOrumors leading to an average of 100 bps of widening (57bond points), the impact on the portfolio would be a loss of0.75%. Even doubling positions to 1% each would lead to a

1.5% drop in returns. In practice, an index-matched portfolio,excluding financials and utilities, would only have roughly45% of its holdings exposed to LBO rumors.

2006 Credit Events & Market Movers

High Grade LBOs (7) Active LBO Speculation

CCU Clear Channel CAR Avis

FSL Freescale Semiconductor CBS CBS

HET Harrah's Entertainment FD Federated

KMI Kinder Morgan Inc. GPS Gap

H Realogy Corp. JNY Jones Apparel

TSG Sabre Holdings RSH RadioShackUVN Univision RRD RR Donnelley

High Grade M&A RRD SLE

ABS Albertsons LUV Southwest Airlines

CD Cendant Corp TRB Tribune Co.

KMG Kerr-McGee Major High Yield LBOs

KRI Knight-Ridder CVC CSC Holdings Inc.

MYG Maytag (WHR) GP Georgia-Pacific Corp.

SVU SUPERVALU (ABS) HCA HCA Inc.

CDS Succession Events STN Station Casinos

AT Alltel Corp.

VZ Verizon


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View Across the Grade: Emerging Market Sovereigns

Emerging Market Debt: 2007 OutlookCarl Ross (212) 272-9040 / [email protected]

We are constructive on emerging market debt in 2007, due to

our expectation of favorable global economic conditions(robust growth and ample liquidity) and reasonably strongfundamentals in developing countries generally. Before wedelve into more detail on the 2007 outlook, it is worthwhile tobriefly consider the 2006 experience.

Salient Points on the 2006 Performance of EM Debt

Returns in 2006 were better than expected. The total return ofour BSEMIX index of emerging markets sovereign debt was8.74% as of mid-December, with positive momentum in themarket likely to carry the return to above 9% for the year. Ourbase-case scenario, which we laid out in January of 2006, wasthat the BSEMIX would return 3.75%, based on 30 bps ofspread contraction and a 100-bp increase in the U.S. Treasury10-year yield, consistent with the firms forecast. In the end,the spread tightening looks to be more than expected (4050bps) and there has been surprisingly little (point-to-point)increase in U.S. Treasury rates at the 10-year sector. In short,2006 turned out to be very close to the bullish alternativescenario we outlined at the beginning of the year.

Most of the returns came in the second half of the year. Theweakness in the Treasury markets in the second quarter led toa decline in the EM debt market, and the total return for thefirst half of the year was a mere 0.30%. In the second half, itwould appear that the market (rightly or wrongly) has taken

the Feds pause in rate hikes as a sign that the U.S. economy isheading into a soft landing. Long term interest rates havefallen, and EM bonds have performed well, returning 8.42%thus far in the second half.

Latin America and high-yielding credits were theoutperformers. As a region, Latin America, with the highestconcentration of high yield sovereigns, has led the gains forthe year. The Latin America component of our BSEMIXindex, has returned 11.11% year-to-date, compared with8.67% for Asia, 3.56% for Middle East/Africa, and 4.17% forEastern Europe.

BSEMIX Ranked Returns YTD as of December 15, 2006

-5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00%

IraqT&T

PolandHungary

KoreaMalaysia

ChinaLebanonTurkey

South AfricaMiddle East/Africa

ChileHong Kong

Eastern EuropeRussia

QatarThailandMexico

Costa RicaNigeria

UkraineSerbiaEgypt

VietnamColombia

AsiaSovereignGuatemalaVenezuela

PakistanPanamaEcuador

IndonesiaKazakhstan

Latin AmericaEl Salvador

BrazilPhilippinesDom. Rep.

JamaicaUruguay

PeruArgentina

Source: F.A.S.T., Bear Stearns Emerging Markets Research.

The 2007 Outlook

We believe that 2007 will be another good year for theemerging market debt asset class, with a lot depending on thepath of the U.S. economy. The path of the U.S. economy hasobvious implications for U.S. interest rates, which affect noonly the prices of emerging market bonds (denominated indollars) but also the global flow of funds toward risk assets. Italso has an effect on emerging country fundamentals. By now

the increase in reserve assets in emerging country centrabanks is well known. The chart below shows the historicaperspective on external debt and foreign exchange reserves inemerging market countriesin effect, a very simplifiedbalance sheet. The chart clearly shows that foreign reserveasset accumulation in emerging market central banks hasmassively outpaced the rise in external debt. In 1998, reservesas a percentage of external debt stood at roughly 27%whereas the same ratio in 2007 is expected to approach 100%Clearly, this is a favorable balance sheet position for emergingcountries.


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Global Emerging Markets: The Balance Sheet Has ImprovedDramatically

600

800

1000

1200

1400

1600

1800

2000

2200

2400

2600

2800

3000

3200

3400

3600

3800

1998 1999 2000 2001 2002 2003 2004 2005 2006(e) 2007(f)

Total External Debt Emerging Region (Public & Private, US$ in Bns)

FX Reserves Emerging Region (US $Bns)

Sources: IMF World Economic Outlook.

We admit that there is a lot of good news priced into theemerging market debt market. But looking simply at likelyrating actions, there is the strong possibility of continued goodnews. The table below lists sovereign credit ratings for the

countries in our BSEMIX index, along with rating outlooks.Of the 37 sovereigns in our index, sixteen have a positiverating outlook from at least one of the major rating agencies,and only two have negative outlooks.

BSEMIX Countries: Ratings & Outlook, December 2006

Co un tr ies Rat in g Ou tl oo k Rat in g Ou tlo ok Rat in g Ou tl oo k

Latin America

Argentina B3 STA B+ STA B STA

Brazil Ba2 STA BB POS BB STA

Chile A2 STA A STA A STA

Colombia Ba2 STA BB POS BB POS

Costa Rica Ba1 STA BB STA BB STA

Dominican Republic /1 B3 NA B POS B POS

Ecuador Caa1 POS CCC+ STA B- STA

El Salvador Baa3 STA BB+ STA BB+ STA

Guatemala Ba2 POS BB STA BB+ STA

J amaica B1 STA B STA NR STA

Mexico Baa1 STA BBB STA BBB STA

Panama Ba1 STA BB STA BB+ STA

Peru Ba3 POS BB+ STA BB+ STA

Trinidad and Tobago Baa1 STA A- STA NR NA

Uruguay /1 B3 NA B STA B+ POS

Venezuela B2 STA BB- POS BB- STA

Asia

China A2 POS A STA A POS

Hong Kong Aa3 POS AA STA AA- POS

Indonesia B1 STA BB- STA BB- STA

Korea A3 POS A STA A+ STA

Malaysia A3 STA A- STA A- STA

Pakistan B1 STA B+ POS NR NA

Philippines B1 STA BB- STA BB STA

Thailand Baa1 STA BBB+ STA BBB+ STA

Vietnam Ba3 STA BB STA BB- STA

Eastern Europe

Hungary /1 A1 NA BBB+ NEG BBB+ NEG

Kazakhstan Baa2 STA BBB STA BBB STA

Poland A2 STA BBB+ STA BBB+ POS

Russia Baa2 STA BBB+ STA BBB+ STASerbia NR NA BB- POS BB- STA

Ukraine B1 POS BB- STA BB- POS

Middle East/Africa

Egypt Ba1 STA BB+ STA BB+ STA

Iraq NR NA NR NA NR NA

Lebanon B3 NEG B- NEG B- STA

Qatar Aa3 STA A+ STA NR NA

South Africa Baa1 STA BBB+ STA BBB+ STA

Turkey Ba3 STA BB- STA BB- POS

Moody's S&P Fitch

Source: Bloomberg. Legend Key: POS = positive outlook; STA = stable outlook; NEG= negative outlook; NR = not rated; NA = not available; /1 = ra tings under review.

Base case scenario. The BSEMIX index spread will tightenby 10-20 bps over the course of the year, to +140 to +150 bpsover U.S. Treasuries. This scenario assumes that the U.Seconomy stays out of a recession and that the Fed, if it movesrates in 2007, will move glacially (meaning +/- 50 bps fromcurrent levels and no more in either direction). Under thisscenario, China is likely to keep growing at roughly 10% in

real terms, commodity prices are likely to remain high andemerging market fundamentals are likely to continue toimprove. We believe that spreads can continue to tightenunder this scenario, though the pace of tightening is likely toslow (from 4050 bps of tightening in 2006). The table belowshows simulations of our BSEMIX index under variouscombinations of spread changes in the BSEMIX index and theU.S. Treasury curve (which we model as simply the 10-yearUST yield). As the chart shows, with a spread of 140150 bpson the BSEMIX, we need stable U.S. Treasury rates for thisasset class to be interesting. A 5.00% 10-year yield in 2007would generate EM index returns of only around 5%, while a6.00% 10-year would wipe out returns.

Upside scenario. The BSEMIX index spread tightens by 30bps to +130 over U.S. Treasuries due to favorablefundamentals, and the inflation outlook in the U.S., contrary toour economists expectation, remains well-behaved. Foreigncentral banks continue to purchase dollar assets, keeping U.STreasury yields low. Under this scenario, the BSEMIX wouldreturn 8%10% (see table below). This scenario wouldcontinue to call into serious question the relative value oemerging market assets, since the current spread over U.STreasuries of the investment grade U.S. corporate index isabout +130 over.

Downside scenario. Downside scenarios could result from

either a series of negative credit shocks in emerging countriesor a significant deviation from the base case scenario for theU.S. economy. Our U.S. economics team would give a higherprobability to the U.S. economy being stronger than expectedinflation pressures being higher than expected and the Fedbeing more aggressive in tightening in 2007 than the markeexpects. The alternative to this would be a scenario in whichthe U.S. economy goes into a recession or near-recession as aresult of weakness in housing and the U.S. consumer. Either ofthese scenarios would be negative for EM debt, but we believethat EM debt is somewhat cushioned from both. If theeconomy is stronger than expected, this will keep upwardpressure on commodity prices, which is beneficial to emerging

countries in general. If the economy is weaker than expectedFed cuts could keep the liquidity machine pumping.


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BSEMIX Expected 12-Month Returns Under Different 10-Year UST Yields and BSEMIX Spread Scenarios

BSEMIX Index Spread Over 10-Year UST (bps)

UST 10-Year Yield +130 +140 +150 +160 +170 +180 +190 +200 +2104.00% 11.98 11.33 10.67 10.01 9.37 8.73 8.09 7.46 6.84

4.25% 10.41 9.76 9.12 8.48 7.84 7.22 6.60 5.98 5.37

4.50% 8.87 8.23 7.60 6.98 6.36 5.75 5.14 4.14 3.94

4.75% 7.36 6.74 6.13 5.51 4.91 4.31 3.72 3.13 2.54

5.00% 5.89 5.29 4.68 4.09 3.50 2.91 2.33 1.75 1.18

5.25% 4.46 3.87 3.28 2.69 2.11 1.54 0.97 0.41 -0.15

5.50% 3.06 2.48 1.90 1.33 0.77 0.21 -0.35 -0.90 -1.45

5.75% 1.70 1.13 0.56 0.00 -0.55 -1.10 -1.64 -2.18 -2.72

6.00% 0.36 -0.20 -0.75 -1.29 -1.84 -2.37 -2.91 -3.44 -3.96

Source; F.A.S.T., EM Fixed Income Research. Note: The current spread of the BSEMIX at the time of writing is +163 bps to U.S. Treasuries.Our base case scenario for 2007 calls for a tightening in spread on the index to +140150 bps.

Regional Outlooks for 2007

In this publication, we stop short of focusing on particularcountries, but we would like to provide the reader with someguidance on our views for the major regions in emergingmarkets. For Latin America, my colleagues Alberto Bernal

and Franco Uccelli believe that the main credit driver will beeconomic growth, since many of the key elections in LatinAmerica are over (Brazil, Chile, Colombia, Ecuador, Mexico,Peru, and Venezuela). Economic growth will reduce thelikelihood of anti-market economic policies. By contrast, mycolleagues who cover Eastern Europe, Middle East and Africa(Tim Ash) and Asia (John Stuermer) believe that politics maybe the key credit drivers in those regions in 2007.

Latin America. We expect 2007 to be yet another good yearfor the Latin American region, the fifth consecutive one ofpositive growth, and the fourth consecutive one showinggrowth of more than 4% year over year, significantly higherthan the long-term average growth rate for the region ofaround 3%. We believe that a combination of high commodityprices, higher investment rates and lower interest rates (thatspurs investment and consumption) should allow LatinAmerica to achieve the 4% number. Argentina and Venezuelamight decelerate in 2006 due to low investment rates in recentyears, but commodity prices are still likely to keep growthrates above trend. Lingering good growth is consistent withstable fiscal stances and continued improvement in debt ratios.

We do not think that 2007 will be a year in which we see thesame amount of erosion in the supply of bonds (i.e. buybacks)from the Latin America region. We believe that 2007 will be ayear in which the demand/supply schedule will be more

aligned. Why is that? First, from the perspective ofgovernments, the carry of local bonds tends is higher than thecarry on foreign debt, especially under a scenario of realexchange rates appreciating further. Second, we believe thatdiminishing returns may be entering the equation at this time.Specifically, we believe that the willingness/logic of furtherreducing external debt may not be that clear any more, at leastjudging from a social welfare point of view. For example,Brazils net public external debt already stands at 0% of GDP.The logic of further depressing that number may not longer be

fully evident. That said, with fiscal accounts in good order inthe region, the likelihood of significant net new issuance fromthe sovereigns is also unlikely.

Asia. There seem to be identifiable potential flashpoints inalmost all political systems in Asia over the next year, taking

the form of elections to be held in 2007, coup attempts orbroadly based efforts to force elected leaders out of powerusing extra-constitutional means, fracturing of politicacoalitions or other groupings that have provided a basis forpolitical and policy continuity in past years, and finally, theNorth Korean bomb. North Korea has proceeded with testing anuclear bomb, with little immediately observable effect onregional political stability. The 2007 elections in the regionwill take the form of regularly scheduled elections(presidential and parliamentary elections in Pakistanparliamentary and local government elections in thePhilippines, a presidential election in South Koreaparliamentary elections in Taiwan, crucial state elections in

India) or potential snap elections (Malaysia, India). We notethat presidential and parliamentary elections are not due inIndonesia until 2009, but many observers believe that politicamaneuvering by parliamentarians seeking re-election andpolitical positioning by potential presidential candidates wilbegin in 2007, making any further effort at meaningfueconomic policy reforms impossible until after 2009. Thedecision of the Yudhoyono government in September to backoff from submitting a bill to parliament that would reformIndonesias controversial labor law might suggest that the2009 political season has already begun. The most interestingelection in 2007 may turn out to be the effort of PresidentPervez Musharraf to get himself re-elected by Pakistans

electoral college.

There is a small but real threat that dissatisfaction witheconomic performance in Asia could spill over into thepolitics. Although real GDP growth rates have ranged between5% and 6% or higher in good years, this outcome has beendriven more by consumption and exports than by investmentand seems not to be creating employment or driving up livingstandards as much as the investment-driven growth prior to1997. Furthermore, Asias export-based economic growthmodel seems to have created sharp regional or urban/rura


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differences in the distribution of the benefits of economicgrowth throughout the region. This discrepancy, interestinglyenough, has become most pronounced in countries that havebeen some of the better-performing countries in the region,such as China, India and Thailand.

Eastern Europe, Middle East, and Africa. Elections are set to

dominate the agenda in Eastern Europe, the Middle East andAfrica region in 2007.

First off is Serbia which elects a new parliament under thenewly approved constitution on January 21, 2007. Theelections are important, as the next government will beexpected to grapple with the difficult issue of the future ofKosovo. The UN-sponsored Kosovo status talks are expectedto rule in favor of independence in 1Q07, which is unlikely togo down well in Serbia proper. The hope will be that a reform-minded government will be elected in Belgrade, which willsee the bigger picture: that a moderate response over Kosovowill reap rewards in terms of Serbias own EU accession bid.

April then sees presidential/parliamentary elections in Nigeriaand presidential elections in Turkey. Nigeria is important froma broader market perspective given its status as a significantoil producer. We expect some political/social unrest aroundthe elections, but it seems likely that the security forces willensure the smooth transfer of power to the successor to theincumbent Obansanjo.

The presidential elections in Turkey, though, look set toproduce more volatility and hence opportunities for investors.The market consensus seems to be that the ruling AKP willnominate a compromise candidate to run for the presidency;the president is elected by parliament, thereby offsetting thechances of a clash with the secular establishment. We believethat the market could well prove to be disappointed as webelieve that the AKP leader and prime minister, Recep TayyipErdogan, is priming himself for a move to the presidentialpalace. This would likely incense the secular establishment inTurkey, which would be fearful that by controlling thepresidency and the government the AKP would be able toswap Turkeys secular traditions for Shariah law. Given theAKPs majority in parliament, it is difficult for the seculariststo block Erdogans appointment as president, but thesecularists will likely fight tooth and nail in the run up toparliamentary elections due in November 2007. The risk ofmajor political unrest and security crises is not insignificant,although we believe that the end result may be a relatively

market-friendly outcome to the parliamentary elections, withthe AKP joining the secular DYP party in a coalitiongovernment at year-end. This suggests considerable marketvolatility in the period AprilNovember.

And, last but not least, Russians elect a new parliament inDecember 2006, and then a new president in March 2008. Wedo not expect any surprises on either, with the party of power,United Russia, expected to produce a landslide victory in theparliamentary elections, followed by a similarly convincing

victory by the anointed Putin successor in March 2008; thusfar it seems set to be the deputy prime minister and chairmanof Russias largest company, Gazprom, Dmitri MedvedevHerein the main factor driving the elections will be thecomplete lack of any substantive opposition force in RussiaOver the longer term, this does raise concerns overaccountability, but in the short term it suggests a stable

succession to a Putin loyalist, which will no doubt beappreciated by investors. In the short term, we believe thatinvestors value stability rather than accountability, and Russiawill continue to offer solid investment opportunities.

Emerging Market Corporate Debt Outlook

Our relatively constructive outlook for sovereigns in 2007 alsospills over into corporatesand thus my colleagues who coverEM corporate debt (Alex Monroy, Robert Schmieder, OkanAkin and Daniel Fan) expect another year of healthy emergingmarkets issuance levels. Assuming continued spreadtightening, we believe that corporates, given that theytypically trade at a spread to sovereign benchmarks, wil

continue becoming more of an outright focus for yield-hungryemerging markets investors, rather than one-off bets. Webelieve this to be particularly the case for countries such asMexico and Brazil, which have shown significant institutionamaturity that has allowed them to weather challengingpolitical situations (such as the recent Mexican elections)which historically might have caused significant sell-offs.

The increase in institutional stability has also led to the growthof local currency debt markets, particularly in Mexico andBrazilbut also in countries such as Argentina, which is stillsorting through the after-effects of the 20012002 pesodevaluation. We expect this trend to continue into othercountries, as political stability takes effect, allowing emergingmarket companies more diversification in their financingsources. We would expect that this trend, over time, could leadto a lower default rate, particularly for companies withprimarily local currency revenues.

The growth of the local currency markets has also led tointeresting investment opportunities for investors not able todirectly invest in local currency assets, such as bond issues byTarjeta Naranja in Argentina and Eletropaulo in Brazil, wherethe borrowed amounts are in local currency and thus carry asignificantly higher coupon (reflecting the higher local interesrates than those in the U.S.), but where payments are made indollars and familiar RegS and 144A structures are in place

Given the success of these deals, we wouldnt be surprised ifwe continued seeing similar structures in 2007.

In addition, during 2006, given the ever-tightening yieldscenario in the United States, we have seen significancrossover interest from traditionally First-World-centric highyield and high grade investors looking for additional yield. Wewould expect that trend to continue into 2007 as generacomfort levels with the asset class, in general, and certainregions or countries, in particular, continue increasing and ascross-border consolidations continue blurring country lines.


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Economics

Growth, Inflation and Monetary Policy Outlook for 2007John Ryding (212) 272-4221 / [email protected] Conrad DeQuadros (212) 272-4026 / [email protected]

Elena Volovelsky (212) 272-4447 / [email protected] Meghna Mittal (212) 272-1961 / [email protected]

Summary

We project that 2007 will be a year of modestly above-trendeconomic growth accompanied by continued elevated rates ofcore inflation. Although the slowdown in growth after thefirst quarter of 2006 was more pronounced than weanticipated, we attribute the bulk of the deceleration ineconomic activity to a steeper decline in residential investmentthan we thought likely and to cutbacks in motor vehicleproduction. Importantly, we have seen little evidence ofspillover effects beyond these two industries and we may havebegun to see tentative signs of stabilization in both of thesesectors. If, as we believe is the case, housing starts and newhome sales have begun to stabilize, then the drag on growth

from residential construction should begin to dissipate in thefirst quarter of 2007 and be largely behind the economy by thesecond quarter. As the forces restraining growth diminish, weexpect real GDP growth to pick up to 3.1% for 2007.

We still judge that monetary policy is accommodative andproviding considerable support to economic activity. We alsosee easy money as the source of continued elevated inflationpressure and we expect core PCE inflation to drift higher in2007 to 2.7%, which is well above the Feds comfort zone of1% to 2%. We expect that once it is clear that economicgrowth is picking up and that core inflation is not easing backtowards its comfort zone, the FOMC will take steps to

modestly tighten monetary conditions. We project that theFed will hike rates twice in 2007, which would take the fundsrate up to 5% by year end, although we do not expect thefirst move to occur until May 2007 at the earliest. Withinterest rate futures pricing in two rate cuts in 2007, we expectthe realization of our forecast will put renewed upwardpressure on yields and keep the yield curve invertedthroughout 2007.

Figure 1. Real GDP

-2

0

2

4

6

8

2000 2001 2002 2003 2004 2005 2006

quarterlya.r.cha

nge;%

Source: Commerce Department

Postmortem of 2006

Nominal GDP growth thus far in 2006 has run half apercentage point slower than we projected a year ago. Overthe first three quarters of 2006, nominal GDP growth hasaveraged 6.3% versus our projection of 6.8%. This shortfalrelative to our forecast has primarily shown up in slower reagrowth as real GDP growth has averaged 3.4% thus far in2006 versus our forecast of 3.8% for the year as a wholeAfter factoring in our estimate of 2%2% for fourthquarter real GDP growth, we expect growth for 2006 to beabout 3.2%. This rate of growth, however, appears to beabove the economys current potential growth rate as judgedby the unemployment rate. In November 2006, the

unemployment rate stood at 4.5% versus 5.0% in November2005. It appears that the potential growth rate for the U.S. hasdeclined significantly. A year ago, our forecast for theunemployment rate for the fourth quarter of 2006 based off aprojection of 3.8% growth was 4.7%, which is above thecurrent unemployment rate.

The distribution of growth through 2006, however, was moreuneven than we anticipated as the drag from residentiainvestment hit strongly after the first quarter. Real GDPgrowth was 5.6% in the first quarter but has slowed to anestimated average pace of about 2.4% since then, as a declinein residential investment subtracted what appears to be slightly

more than one percentage point from real GDP growth. Theother sector that has weighed more heavily on growth than weanticipated has been motor vehicle production, as theproduction of motor vehicles and parts declined at anannualized rate of 8.5% since June.

In our judgment, there is no evidence that the weakness inhousing and autos has spilled over into the rest of theeconomy. In the first 10 months of 2006, real consumespending growth has averaged 3.1% at an annual rate, whichhas largely matched the 3.0% growth rate in real disposableincome. This growth occurred despite a flattening out inwealth creation as household real net worth rose by only $1.4trillion at an annual rate over the first three quarters of the year

versus an average annual increase of $2.9 trillion over theprevious three years. At the end of the third quarterhousehold net worth totaled $54.1 billion, or 5.6 times annualdisposable income, suggesting that in aggregate the householdsector is in sound financial shape. In short, growth has slowedbecause of the traditional multiplier impact of reducedresidential investment. There is nothing in consumer behavioin 2006 to suggest that a pullback in mortgage equitywithdrawal has held back consumer spending and growth.


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On the inflation and monetary policy fronts, our projectionshave been closer to the mark. We projected that core PCEprice inflation would average 2.4% in 2006 and, through thefirst 10 months of the year, the average rate has been 2.5%which is at the top of the Feds forecast range for 2006. Weargued that the most likely path for Fed policy was that thefunds rate would plateau at 5% in 2006, but added that a

4.7% unemployment rate, and2.4% core PCE inflationcould induce the Fed to raise rates to perhaps 5% by the endof the year. The outcome for policy was in between thesetwo scenarios as the fed funds rate target reached 5% bymid-year and was held at that rate for the rest of the year. Incontrast, interest rate futures were pricing in a 4% fed fundsrate by the middle of 2006.

Our major forecasting error was again on the level of bondyields. From a fundamental perspective, we looked for a 10-year Treasury yield of 5% by mid-year. However, weargued that the next most likely scenario was that recyclingof Fed accommodation into the U.S. bond market by foreignofficial buyers in Asia could continue to hold long yields incheck, which could result in the yield curve inverting in early2006. The year has been a mixture of these two scenarios asfundamentals pushed 10-year yields up to a monthly averageof 5.1% in June, but, seemingly triggered by the pause in ratehikes, foreign buying has helped lower these yields to 4.6%and we have seen the yield curve invert.

Growth and Inflation Outlook for 2007

The starting point for our forecast is always our assessment ofthe stance of monetary policy. Our assessment of monetarypolicy is primarily based upon a neo-Wicksellianinterpretation of the value of the dollar against an array of

alternative stores of value, including gold, commodities andother foreign currencies. All of these indicators show thatdespite the rate hikes in 2006, the value of the dollar has lostground. Thus far in 2006, the dollar has fallen roughly 17%against gold, 42% against a basket of industrial metals and 5%against major currencies. If monetary policy wasaccommodative at the end of 2005, it is hard for us, given thedeterioration in the dollars value, to avoid reaching theconclusion that monetary policy is still accommodative andthat interest rates remain below their neutral level.

An accommodative monetary policy has cushioned theeconomy in the face of adjustments in housing and autos.This is the key difference between the slowdown in 2000,which was a precursor to recession and rate cuts in 2001, and2006. In 2000, tight monetary policy (as signaled by gold andcommodity price deflation and a strong dollar) provided nosupport to growth as the tech bubble burst and, as financialconditions tightened, cash-strapped corporations were forcedto slash capital spending budgets, throwing the economy intorecession by March 2001. At the present time, not only arehousehold balance sheets in solid shape, but corporate profitgrowth and cash flows are strong and largely matchinvestment spending levels. For the first three quarters of

2006, nonfinancial corporate capital spending has exceededcorporate internal funds by only $38 billion at an annual rateMeanwhile, corporations have returned $387 billion toshareholders in the form of dividends on the same basis. Inother words, nonfinancial corporate net funding needs are onlyone-tenth of the dividends that they returned to shareholdersthis year.

Figure 2. Price of Gold

200

300

400

500

600

700

800

1996 1998 2000 2002 2004 2006

$/troyounce

Source: Wall Street Journal

We view the housing market as undergoing a one-timeadjustment from unsustainable levels of construction and priceappreciation. In our forecast, as this adjustment draws to aclose, the dampening effects of lower residential investmenare lifted and economic growth picks back up to a modestlyabove-trend pace. Also helping growth is a reduced drag onreal incomes from energy prices, which have pulled backsignificantly in recent months. We see real GDP growth in2007 averaging 3.1%, which is in line with the growth rate ofconsumer spending seen thus far in 2006.

A year ago, we would have viewed 3.1% growth as beingmodestly below potential growth. However, the continueddecline in the unemployment rate through 2006 suggestsotherwise, and we now project that the unemployment ratewill fall to 4% by the end of 2007 from 4% at the presentime. The decline in the unemployment rate should put furtheupward pressure on wage increases, which in turn should helpsupport the growth of household incomes.

In our forecast framework, inflation is a function of the stanceof monetary policy, not the unemployment rate. However, weview easy money as producing a further moderate rise in coreinflation in 2007. We expect core PCE price inflation to riseto 2.7% in 2007 from a projected increase of 2.3% in 2006Economy-wide inflation in the form of the GDP deflator isseen at 3.0% in 2007, which, combined with real growth of3.1%, would put nominal GDP growth at 6.2% next year.


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Figure 3. Core PCE Price Inflation

1.0

1.5

2.0

2.5

3.0

1995 1997 1999 2001 2003 2005

12-month

change;%

Source: Commerce Department

Fed Seen Hiking Rates Twice in 2007

If realized, we think our growth, unemployment rate andinflation forecast would likely prompt the Fed to modestly

tighten monetary policy in 2007. The Fed has made it clearthat policy adjustments are dependent on incoming datarelative to its forecast and the three primary variables that theFed publishes in its forecast are real GDP growth, theunemployment rate and core PCE inflation. In July 2006, theFOMCs central tendency ranges for these variables for 2007were: 3%3% for real GDP growth; 4%5% for the fourthquarter unemployment rate; and 2%2% for core PCEinflation. While we see real GDP in the FOMCs forecastrange for 2007, the Fed has lowered its estimate for potentialgrowth since July and our forecast for the unemployment rate,which is the principal driver of the Feds inflation model, iswell below the Feds range. In addition, we see core inflationrising rather than falling in 2007. Under these circumstances,we would expect the Fed to snug rates higher in 2007 and welook for two rate hikes, to 5%, before the end of 2007.However, before the next hike takes place, we believe thatgrowth would have to have picked up to about 3%, thehousing market would have to have clearly stabilized, and thatcore PCE inflation would have to have edged up to at least2%. We think that the earliest FOMC meeting at whichthese conditions would be satisfied is likely to be the Maymeeting. Until then, therefore, we expect that the Fed willhold rates steady at 5%, and maintain its bias to higherinflation and tighter policy.

Yields Expect to Rise

We recognize that for the last two years, bond yields havebeen lower than we were expecting as a result of strongforeign (especially official) purchases of U.S. fixed income(particularly out of Asia and, more recently, OPEC). Theforward structure of interest rates is pricing in about two

quarter-point rate cuts in 2007. While we expect the Fed tohike rates in 2007, at a very minimum we judge rate cuts to beunlikely. As rate cuts fail to materialize, we would expecyields to drift highera move that is likely to gain momentumif the market begins to anticipate rate hikes. However, unlesthere is a major change to exchange rate policies, especially inAsia, we would expect continued strong official flows into the

U.S. bond market, which we see supporting the intermediate-to long-end of the yield curve. It seems likely to us, thereforethat the yield curve will remain inverted throughout 2007 andthat the degree of inversion might increase. By the end o2007, we look for 10-year yields to have risen back to the highyield level of around 5% that was seen in 2006.

Forecast Risks

As far as quantifiable downside risks to economic growth areconcerned, the primary risk remains that the housingcontraction becomes deeper than we currently anticipate andthat this spills over into consumer spending. However, wethink that GDP growth would have to slow to below 2% for atleast two quarters and that core inflation would have tomoderate towards 2% before the Fed would consider cuttingrates under this scenario. Under unquantifiable risks, we haveto acknowledge the ever-present risk of terrorism or severelyheightened geopolitical tensions over the nuclear ambitions ofIran or North Korea. In this category, the greatest risk toeconomic growth is likely to be developments in relations withIran, that have the potential to significantly impact oil prices.

Our greatest concern, however, remains upside risks toinflation and yields, and downside risks to the U.S. dollarGlobal liquidity has expanded rapidly in recent years asevidenced by the more than doubling of world foreign

exchange reserves from the end of 2001, when they stood at$2.1 trillion, to todays level of $4.8 trillion. Much of thisreserve accumulation has taken place in Asia, where the topseven official holdings of foreign exchange reserves accounfor about half the worlds total holdi

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