JP Morgan's "US Fixed Income Weekly" report 9/26/2011

US Fixed Income Strategy 26 September 2011

AC Indicates certifying analyst. See last page for analyst certification and important disclosures.

US Fixed Income Weekly

Cross Sector Srini Ramaswamy, Kimberly Harano We are cautious on risky assets and we prefer to overweight sectors with lower exposure to Europe and those that offer attractive carry-to-risk after adjusting for European risk. Spread risk is more attractive than duration risk. Stay cautious on credit.

Governments Terry Belton, Meera Chandan, Kim Harano, Renee Park Treasury valuations are extremely rich, but near-term factors suggest the rally has legs. Increased Fed buying in the long end will increase STRIPS reconstitutions. Stay neutral on Agencies.

Investment-Grade Corporates Eric Beinstein We stay underweight as spreads are not wide enough to properly reflect the dual risks of a recession and significant event risk in Europe.

Municipals Peter DeGroot, Josh Rudolph Investors who hold longer-dated BABs and pay above a 14% marginal effective tax rate should consider selling BABs and purchasing similarly rated tax-exempt bonds for sizable gains in taxable equivalent yield.

Special Topic: A Euro recession and spillover risks David Mackie A second harder debt restructuring in Greece now seems inevitable and a mild recession in the Euro area is likely to start in 4Q. A deep recession will only be avoided if the mechanisms to limit contagion are dramatically upsized and actively used.

Contents

Cross Sector Overview 2

Economics 5

Treasuries 10

Agencies 17

Corporates 19

Municipals 23

Special Topic 30

Forecasts & Analytics 43

Market Movers 47

Terry Belton Srini Ramaswamy Alex RoeverAC

US Fixed Income Strategy US Fixed Income Weekly September 26, 2011

Srini RamaswamyAC Kimberly L. Harano J.P. Morgan Securities LLC

2

Cross Sector Overview

The FOMC surprised markets with an aggressive Operation Twist, announcing its intentions to buy a substantial fraction of long-end Treasury debt and reinvest maturing Agencies/MBS into MBS

The European crisis is likely to intensify; we now think a harsher Greek debt restructuring is inevitable, implying worse macroeconomic outcomes for Greece and the Euro area. We expect the Euro area to fall into recession next quarter, adding downside risk to our US growth forecast

In this environment, we are cautious on risky assets and we overweight sectors with lower exposure to Europe and those that offer attractive carry-to-risk after adjusting for European risk…

…On this basis, we find that spread risk is more attractive than adding duration risk; stay neutral on duration and overweight MBS

However, a broader deleveraging event remains a possibility, which could affect any and all markets. The sharp sell-off in commodities and EM currencies this week is an ominous sign, and suggests some deleveraging may already be underway

Market views

Markets treaded water early in the week, only to collapse on Wednesday and Thursday before stabilizing somewhat on Friday. European sovereign CDS continued their relentless widening, equities plummeted, credit spreads widened, and 10-year Treasury yields reached new all-time lows (Exhibit 1). The beneficiaries of the risk-off trade were the dollar and the yen, with even gold appearing to take a breather. After this week’s moves, our revamped “crisis meter,” which compares the cheapening in the current cycle to the average cheapening over late 2008 and last summer, shows significant stress across many markets (Exhibit 2).

The tone of news and data were mixed to negative this week, though it is difficult to pinpoint a singular trigger for the risk-off trade. On Tuesday, S&P downgraded

Italy from A+ to A with outlook negative, and on Wednesday, Moody’s downgraded the long-term ratings of Bank of America and Wells Fargo and downgraded

Exhibit 1: Risky assets plummeted this week as a massive risk-off trade took hold Current level,* change since 9/16/11, quarter-to-date change, and change over 2Q11 for various market variables

Current Chg from 9/16 QTD chg 2Q11 chg

Global Equities (level)S&P 500 1136.4 -79.6 -184.2 -5.2

E-STOXX 2026.0 -133.3 -822.5 -62.4

FTSE 100 5066.8 -301.6 -878.9 36.9

Nikkei 225 8560.3 -303.9 -1255.8 61.0

Sovereign par rates (%)2Y US Treasury 0.259 0.064 -0.212 -0.301

10Y US Treasury 1.886 -0.265 -1.374 -0.277

2Y Germany 0.348 -0.127 -1.218 -0.162

10Y Germany 1.778 -0.128 -1.272 -0.346

2Y JGB 0.133 -0.006 -0.038 -0.023

10Y JGB 0.931 -0.030 -0.231 -0.143

5Y Sovereign CDS (bp)Greece 5109 758 2998 1019

Spain 418 48 156 29

Portugal 1340 202 543 206

Italy 499 50 328 24

Ireland 884 30 93 128

Funding spreads (bp)2Y EUR par swap - par gov't spd 105.3 5.0 44.1 -0.7

2Y USD par swap - par gov't spd 25.9 -4.6 3.5 3.8

EUR FRA-OIS spd 61.7 -2.8 32.3 3.1

USD FRA-OIS spd 41.6 -1.2 20.7 -0.2

1Y EUR-USD xccy basis -77.4 -12.9 -51.3 0.1

CurrenciesEUR/USD 1.353 -0.026 -0.097 0.031

USD/CHF 0.903 0.027 0.061 -0.073

USD/JPY 76.28 -0.44 -4.77 -1.73

JPM Trade-weighted USD 81.98 2.49 4.38 -1.46

Spreads (bp)30Y CC MBS L-OAS 64.9 -4.7 27.2 9.6

10Y AAA CMBS spd to swaps 355.0 35.0 135.0 30.0

JULI (ex-EM) Z-spd to Tsy 239.5 18.1 87.0 14.9

JPM US HY index spd to worst 775.1 35.7 208.1 50.1

EMBIGLOBAL spd to Tsy 461.9 75.0 173.4 -10.4

MAGGIE (Euro HG spd to gov ies) 68.0 2.8 19.6 6.3

US Financials spd to Tsy 318.3 31.3 137.2 21.1

Euro Financials spd to govies 300.1 20.8 130.3 20.1

10Y AAA muni/Tsy ratio (level) 104% 5.4% 20.1% -5.8%

30Y AAA muni/Tsy ratio (level) 118% 8.7% 19.1% -7.4%

CommoditiesGold futures ($/t oz) 1739.40 -39.80 229.00 86.60

Oil futures ($/bbl) 79.85 -8.33 -15.57 -11.30

* 9/22/11 level for Europe and US corporate credit spreads, JGB yields, and the J.P. Morgan trade-weighted USD index; 9/23/11 level for all others.



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the short-term ratings of Bank of America and Citigroup, but these ratings actions have long been anticipated. In Europe, there was little progress on the policy front this week, and the news flow was largely negative, with headlines around potential delays in parliamentary approval of EFSF changes.

In the US, economic data were mixed. In the housing sector, the NAHB housing market index fell 1 point to 14, and housing starts fell 5% in August, but on the other hand, existing home sales rose 7.7% in August, and the FHFA house price index showed a 0.8% gain in July. Labor market data were slightly more positive, with initial jobless claims falling to 423K from an upwardly revised 432K.

Of course, the big event for the week was the FOMC statement on Wednesday, and on the margin, the Fed over-delivered: it announced it would sell $400bn front-end securities and buy an equivalent amount of longer-dated securities by June 2012, with 29% of the purchases coming in the 20-30 year bucket, a much higher fraction than expected. The Fed did not lower interest on excess reserves, but it also surprised investors by announcing that it would reinvest maturing Agency debt and MBS back into MBS. Long-end Treasuries and MBS rallied sharply on the news. Despite the stronger-than-expected stimulus, however, risky assets sold off, perhaps driven by the bleak characterization of growth: the Fed wrote that “there are significant downside risks to the economic outlook, including strains in global financial markets” and maintained an easing bias.

Looking ahead, we expect the environment for risky assets to remain challenging given global growth headwinds and the intensifying European crisis. Given the lack of meaningful positive developments, we remain bearish on Europe. In the near term, the possibility that small countries such as Slovenia, Slovakia, and Estonia vote against EFSF ratification and implementation risk around Greece’s reform programs are risks. Over the medium term, however, we now think that a much harder debt restructuring seems inevitable, which will likely produce worse macroeconomic outcomes for both Greece and the entire Euro area (see Special Topic).

We now expect the Euro area to fall into recession next quarter, with the contraction lasting until the middle of next year (Exhibit 3). As a result, we also expect the

ECB to cut its policy rate by 50bp to 1.0% at the next meeting, and look for more QE from the BoE in October. If policymakers act very aggressively, by supplying liquidity to banks and sovereigns and recapitalizing banks, we expect a mild recession, but the global repercussions will be significant. At this point, we are not revising our US GDP forecast, but we note that downside risk to our growth forecast has increased.

In this environment, we favor sectors with lower exposure to Europe and/or higher carry-to-risk ratios

Exhibit 3: We now look for the Euro area to fall into recession next quarter J.P. Morgan forecast for real GDP, %q/q, saar

3Q11 4Q11 1Q12 2Q12 3Q12 4Q12

Euro area 0.5 -0.5 -1.0 -1.5 0.0 1.0

Germany 1.5 -0.5 0.0 -0.5 0.5 1.0

France 1.0 0.0 -0.5 -1.0 0.5 1.0

Italy -1.0 -1.5 -1.5 -2.5 -0.5 0.5

Spain 0.0 -1.0 -1.0 -1.5 0.0 1.0

Greece 5.0 -3.0 -6.0 -10.0 -8.0 -3.0

Ireland 1.0 0.0 -0.5 -1.0 0.5 1.0

Portugal -5.0 -3.0 -3.0 -3.5 -1.5 0.0

Source: “Directing the Greek tragedy: default, a regional recession and spillover risks,” David Mackie et al, 9/23/11.

Exhibit 2: Our revamped crisis meter shows significant stress this week Ratio of current cheapening to 2008 and 2010 cheapening* for select variables; as of 9/23/11; %

0

50

100

150

200

250

EM currency avg

0

50

100

150

200

250

1Y EUR/USD x-ccy basis swap

0

50

100

150

200

250

French bank CDS avg

0

50

100

150

200

250

Euro sovereign CDS avg

0

50

100

150

200

250

EUR/USD

* Current cheapening is the worst level minus the best level in the month before 6/30/11. The 2008 cheapening is the difference between the worst level over 9/1/08-12/31/08 and the best level in the prior 1-month period. The 2010 cheapening is the difference between the worst level over 4/15/10-7/15/10 and the best level in the prior 1-month period. Note: EM currency average is the average of BRL, INR and MXN. French bank CDS average is the average 5-year CDS spread for Societe Generale, Credit Agricole and BNP Paribas. Euro sovereign CDS average is the average 5-year CDS spread for France, Italy and Spain.



4

after accounting for Europe risk. In Exhibit 4, we present carry-to-risk ratios for various instruments, where risk is defined as the idiosyncratic price risk based on historical volatility plus the additional price risk due to Europe. The risk due to Europe is calculated using the stylized model for spreads presented last week (see Cross Sector Overview, US Fixed Income Weekly, 9/16/11) and assumes a one-standard deviation worsening in the European crisis (proxied by the average of selected French bank CDS spreads). As the exhibit shows, for credit assets, the risk from Europe is positive and increases total risk in the position, whereas for Treasuries, which tend to rally when the crisis intensifies, the risk from Europe is negative and lowers total risk in the position. Despite the beneficial impact from Europe, however, Treasuries appear unattractive from a risk-adjusted carry perspective. Indeed, although risky assets have greater (adverse) exposure to Europe, given the recent cheapening, adding credit risk now looks more attractive than duration risk. Although Treasuries do look extremely rich, we think the rally could continue over the near term as investors rebalance positions and mortgage hedgers are forced to add duration, so we stay neutral on duration (see Treasuries).

One sector that has very low exposure to Europe is MBS, and given the Fed’s decision to reinvest maturing Agency/MBS securities into MBS, we turned positive on the sector.

Our framework outlined above is useful in identifying sectors that are attractive in an environment where the European crisis is expected to intensify. However, we caution that this framework may understate the exposure of various sectors to Europe, in the event that a much broader deleveraging event takes hold. Should that occur, any and all markets could be affected. In an ominous sign, there is some evidence that such a deleveraging event may be beginning. As Exhibit 5 shows, commodities and EM currencies sold off sharply this week, with commodities already cheapening more than they did in the aftermath of the Lehman failure.

With these concerns in mind, we turn neutral (from overweight) on CMBS and limit directional exposure and prioritize liquidity when adding risk. We also stay underweight high grade. Spreads are already near recession levels, but we do not think they are wide enough to reflection recession plus significant event risk

in Europe. In addition, if investors start to reduce exposure as a result of the recent underperformance, we expect spreads to widen significantly further (see Corporates). Similarly, in high yield, although we believe high-yield bonds are attractive from a relative value standpoint, spreads are likely to continue to move wider because European sovereign and banking risks appear likely to keep volatility elevated.

Exhibit 5: The sell-off in commodities and EM currencies this week suggests that broader deleveraging may already be occurring Statistics for various commodities and currencies, and recent cheapening versus cheapening in previous crisis*

Current

level

Best level in

1M before

6/30/11

Recent

cheapening

(% )

Worst level

over 9/1/08-

12/30/08

Best level in

1M before

9/1/08

Cheapening

(% )

Recent/

prev ious

cheapening

Copper futures ($/lb.) 327.20 427.20 23% 326.60 356.10 8% 283%

Oil futures ($/bbl.) 79.85 101.93 22% 109.37 121.41 10% 218%

NZD/USD 0.78 0.83 5% 0.69 0.73 5% 102%

AUD/USD 0.979 1.074 9% 0.841 0.930 10% 92%

USD/TWD 30.418 28.684 6% 33.550 30.666 9% 64%

USD/INR 49.24 44.64 10% 50.34 41.96 20% 51%

USD/SGD 1.296 1.230 5% 1.532 1.372 12% 46%

USD/MXN 13.7 11.6 17% 13.9 9.9 40% 43%

USD/CLP 516.0 466.0 11% 681.0 510.8 33% 32%

USD/BRL 1.850 1.561 19% 2.490 1.564 59% 31%

USD/KRW 1166.0 1073.9 9% 1513.0 1015.9 49% 18%

USD/IDR 8935.00 8512.00 5% 12675.00 9072.50 40% 13%

Current period Previous crisis (2008)

* Cheapening calculated such that positive number implies cheapening, and negative number implies richening.

Exhibit 4: Credit risk now looks more attractive than duration risk Yield, 3-month carry*, duration, general risk**, Europe risk***, and annualized carry to risk; bp of notional unless otherwise indicated

Yield

(% )

3M

carry

Duration

(y rs)

General

risk

Europe

risk

Ann.

carry / total

risk

JULI ex-EM 4.18 99 7.1 189 85 0.73

JPM HY index 8.66 150 4.3 307 128 0.69

EMBIGLOBAL 6.04 138 6.9 274 136 0.68

30Y current cpn MBS 2.85 71 6.8 295 5 0.47

10Y AAA CMBS 5.35 129 9.3 558 22 0.44

2Y Tsy 0.20 5 1.7 55 -6 0.20

10Y Tsy 1.71 43 9.2 711 -99 0.14

3Y Tsy 0.33 8 2.7 142 -12 0.13

5Y Tsy 0.77 19 4.7 344 -34 0.12

30Y Tsy 2.78 69 21.0 1370 -247 0.12

* One-fourth of the yield minus the 3-month T-bill yield. ** 2-year standard deviation of 3-month changes in yield, multiplied by duration. *** Partial beta with respect to French bank CDS in our stylized model for spreads (see Cross Sector Overview, US Fixed Income Weekly, 9/16/11) multiplied by 1 standard deviation move in French bank CDS (43.3bp), multiplied by duration.

Economic Research US Fixed Income Weekly September 26, 2011

Robert MellmanAC Michael Feroli J.P. Morgan Chase Bank

5

Economics

Inflation and core inflation are both running about 3% saar in 3Q11

Rise in inflation mainly reflects the prior surge in commodity prices and weakening in the dollar

Most influences point to much lower inflation ahead; rising rent and OER are possible exceptions

The forecast for current-quarter real GDP growth has been revised down to 1.0% saar from a forecast of 2.5% in late July and 3.0% at the beginning of the quarter. At the same time, the current-quarter inflation forecast has been revised much higher and looks for the CPI to increase 3.2% saar this quarter and for the core CPI to rise 2.9% saar. At the beginning of the quarter the forecast looked for both the CPI and the core CPI to increase only 1.2% saar.

At first glance the rise in inflation looks anomalous against the backdrop of persistently disappointing US and global growth and hints at an intractable stagflation problem. But it is very likely that the rise in both inflation and core inflation will prove temporary and soon recede. In this regard, the inflation performance in early 2008 provides a useful model. Then, as now, inflation rose while the economy was weakening. And then, as now, the rise inflation mainly reflected the upward pressure on goods prices from much higher commodity prices and a weakening dollar. When commodity prices eased and the value of the dollar finally started to recover, the 2008 rise in inflation proved short-lived and by 4Q08 inflation and core inflation had turned sharply lower.

A similar outcome should be expected this time around. The earlier surge in commodity prices has already given way to declines, and the dollar has shifted direction from weakness to appreciation. Both inflation and core inflation should retreat over the next few months. The forecast looks for headline inflation of only 0.5% saar in 4Q11, reflecting the lower oil price, and a downside break in core inflation to only 1.2% saar. Both headline and core inflation are expected to average slightly above 1.0% in 2012. Core inflation is not expected to plunge

Exhibit 1: PCE price index and core PCE price index, with forecast %ch saar, 3m/3m

-1

0

1

2

3

4

5

2010 2011 2012 2013

ForecastPCE price index

Core PCE

price index

Exhibit 2: CPI for core goods and core services %ch saar, over 3 months

-2

0

2

4

6

Jan 09 Jul 09 Jan 10 Aug 10 Feb 11 Aug 11

Core goods

Core

serv ices

Exhibit 3: Commodity prices and the trade-weighted dollar %ch saar over 3 months, both scales

-40

-20

0

20

40

60

80

Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11

-30

-20

-10

0

10

20J.P. Morgan commodity price index

Real broad dollar



6

quite as sharply as in late 2008. The prices of both homeownership and rents are captured in the housing rental market, and falling rental vacancy rates (as households shift from homeownership to renting) are now putting some upward pressure on rents.

The rise in inflation looks temporary

While the severity of current-quarter inflation was not anticipated, it is easy to understand. The J.P. Morgan commodity price index surged more than 60% saar in the six months through April, and higher commodity prices have been passed through into higher energy prices, higher food prices, and higher prices for a variety of other goods. Similarly, the dollar continued to weaken through April, with related broad-based upward pressure on import prices. Inflation has also been temporarily boosted by motor vehicle shortages and price increases associated with the earthquakes in Japan. The combined effect of these influences has resulted in a broad-based surge in goods prices. The August CPI for core goods is running 5.4% saar (measured 3m/3m), its most rapid rate of increase in 20 years. Price increases for both new vehicles and apparel (again 3m/3m) have been running roughly 15% saar.

Each of the influences that was pushing up core prices is now receding. Commodity prices peaked in April and have been drifting lower since. The dollar has been on an appreciating trend since May. And an increasing supply of vehicles has allowed vehicle prices to stabilize the past two months, although the earlier price spike has not yet been reversed. Especially in light of soft consumer spending growth, there is every reason to expect core goods prices to slow dramatically, if not decline, over the next few months. Pipeline prices have already slowed decisively, and further slowing is likely. The core intermediate PPI (core materials and parts) has decelerated from 13.5% saar in the three months through April to only 1.7% saar in the last three months. And over this period, nonfuel import prices have slowed from 8.8% to 1.3%.

But rents have been accelerating

The combination of tame labor costs, falling financing costs, declining commodity prices, a stronger dollar, and weak growth all argue for much slower inflation ahead. But there is one influence pushing the other way (that

Exhibit 4: Owners’ equivalent rent (OER) and rental vacancy rate %ch saar, over 3 months Sa

-1

0

1

2

3

4

Feb 07 Jan 08 Dec 08 Oct 09 Sep 10 Aug 11

9.0

9.5

10.0

10.5

11.0

11.5OER Rental v acancy rate

Exhibit 5: PCE price index and core PCE price index, 2007-2009 %ch saar, 3m/3m, both scales

-4

-2

0

2

4

6

2007 2008 2009

0.5

1.0

1.5

2.0

2.5

3.0PCE price index

Core PCE price index

Exhibit 6: Commodity prices and the trade-weighted dollar, 2007-2009 %ch saar, 3m/3m, both scales

-100

-50

0

50

100

2007 2008 2009

-40

-20

0

20

40J.P. Morgan commodity

price index

Real, broad dollar



7

was not present when core inflation plunged in late 2008). The prices of rent and of homeownership are both measured in the rental market. The flip side of falling homeownership has been increases in the number of renters and a shift to relatively low rental vacancy rates. The result has been an acceleration in rent and owners’ equivalent rent from outright declines early in the expansion to moderate increases of more than 2.5% saar in the past three months. Further near-term acceleration is possible, although certainly not inevitable given anemic income growth. Rent and OER are numerically important since they comprise a combined 39.9% of the core CPI and 17.1% of the core PCE price index.

A similar pattern three years ago

The pattern of rising inflation through the early stages of economic weakening also occurred into the recent downturn. Although the US unemployment rate hit bottom in May 2007 and was rising for six months before the US entered recession in December, both inflation and core inflation accelerated into 2008. Quarterly growth rates for both the PCE price index and the core PCE price index held above the top of the Fed’s informal 1.5% to 2.0% inflation target until the fourth quarter of that recession year.

Then, as now, inflation did not reflect tight labor markets. Unemployment was rising steadily and growth of hourly labor cost remained broadly constant. Instead, the pass-through of surging commodity prices and a weakening dollar were the key factors pushing up inflation. The monthly average oil price did not peak in 2008 until June (at a monthly average of $134/barrel of WTI), and the retail price of gasoline similarly peaked around midyear, well above $4.00 per gallon. The weaker dollar brought a sharp acceleration in import prices, both for all nonfuel prices and for consumer goods, through 2Q08. But when the surge in commodity prices ran its course and the dollar started to move higher, inflation quickly receded.

The forecast continues to look for disappointing 1.0% real GDP growth for both this quarter and over the coming year. Incoming data for the current quarter are generally tracking slightly to the high side of the 1.0% forecast. But incoming data do not yet fully reflect the effects of the decline in equity prices to date on wealth and confidence. This past week’s decline in equity prices

Exhibit 7: Price of equities and price of gasoline Index, Jan 1=1.00, both scales

0.85

0.90

0.95

1.00

1.05

1.10

1.15

Jan Mar May Jul Sep

0.6

0.8

1.0

1.2

1.4

S&P 500

Price of gasoline, first future

Exhibit 8: Initial jobless claims ‘000s, sawr, 4-wk mov avg; adj for Verizon strike

385

400

415

430

445

Jan 11 Mar 11 May 11 Jul 11 Sep 11

Exhibit 9: Homebuilders survey and mortgage purchase applications Sa Mar 1990=100, Sa

12

14

16

18

20

22

24

Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11

160

180

200

220

240

260Homebuilders surv ey ,

current sales

Mortgage purchase

applications



8

(and, secondarily, this week’s downward revision to the forecast for foreign growth) highlights downside risks to an already subdued growth forecast.

So far, at least, the economic data are more consistent with slow growth rather than recession. Initial jobless claims are closely watched as the most reliable high-frequency indicator of economic momentum. Initial claims for the latest reporting week, the week of September 17, declined 9,000 to 423,000 and the 4-week average held at about 421,000, readings well within the range of claims so far this year. The latest report for the week of the September labor market survey showed both initial claims and the 4-week average have increased about 20,000 since the week of the August labor market survey (adjusted for the effect of the Verizon strike in August). Claims have not been a very reliable predictor of monthly swings in net hiring, but the rise over the past month suggests another weak payroll report for September.

Auto industry guidance suggests that increased availability of Japanese nameplates boosted new car and light truck sales in September. The forecast looks for sales to rise to a 12.8mn pace from 12.1mn in August, and an average 11.8mn over the prior three months. The sale pace would still be below the 13.0mn average in 1Q11, before the dislocations in Japan. But it would be viewed as a reasonably positive development against the backdrop of plunging equity prices and confidence.

Most of the other economic reports this past week describe conditions in the housing industry. Some housing reports were slightly positive and others slightly negative. But the main message is that housing activity remains stuck at very depressed levels. The upcoming calendar includes August reports on income and spending, durable goods, and new home sales. And there is likely to be special attention on the four regional business surveys for September out next week.

Review of recent housing data

September reports show home sales slipping. The timeliest reports on housing are demand indicators for September, the latest weekly reading on mortgage purchase applications, and the September Homebuilders survey. Both show modest weakening in demand conditions this month.

Mortgage purchase applications declined 4.4% sawr to the lowest weekly reading since February. Mortgage purchase applications had declined 6.1% samr in August and are down about another 7% so far in September. So it does seem that the recent declines in equity prices and confidence have spooked potential homebuyers. (While the trend is slipping, there were upward revisions to reported levels of mortgage applications over the last few months averaging more than 10%.) The September Homebuilders survey confirms that sales are slipping: the headline reading and the component measuring current home sales both edged down a point from already low levels.

Housing permits trending higher. The August report on housing starts and permits was mixed. Housing starts

Exhibit 10: Housing permits Mn units, saar, both scales

0.35

0.40

0.45

0.50

0.55

Jan 10 May 10 Sep 10 Dec 10 Apr 11 Aug 11

0.10

0.15

0.20

0.25Single family Multifamily

Exhibit 11: Household debt service ratio and financial obligations ratio % of disposable income, both scales

10

11

12

13

14

80 85 90 95 00 05 10

15

16

17

18

19Debt serv ice ratio

Financial obligations ratio



9

declined 5.0% samr, with most of the decline in multifamily activity following large gains in prior months. The decline was at least partly due to Hurricane Irene, however, judging by the 29.1% plunge in starts in the East. Even with the August decline, total housing starts so far in 3Q11 are running 12.0% saar above the 2Q11 average.

Housing permits, a better measure of the trend in activity, increased 3.2% in August and both total permits and single-family permits reached their highest level since January. The upward trend in permits for multifamily housing has been especially strong this year, albeit off of extremely low levels, as the shift from homeownership to renting has boosted demand for rental units and brought down rental vacancy rates. Total housing permits so far in 3Q11, like starts, are running about 12% above their 2Q11 average.

Existing home sales, which had been trending lower most of this year, increased 7.7% samr in August. The increase may well have been the result of buyers front-loading purchases ahead of the reduction in limits for conforming loans at the end of this month. This is consistent with the especially large increase in the West (up 18.3%), a region with more expensive homes than in other regions. Recent declines in mortgage purchase applications strongly suggest that the August sales increase will not be sustained.

July home prices up. House price measures that adjust average prices for the distribution of sales by size, quality, and location are reported with some lag. This week’s report on the FHFA house price index shows some firming in house prices into the summer. The FHFA index rose 0.8% samr in July on top of an 0.7% increase the month before. The CoreLogic house price index increased 0.1% samr in July (and 1.1% ex. distressed sales). The more widely followed Case-Shiller house price index for July (reported Tuesday) is expected to post a 0.3% samr increase. Recent price increases follow earlier declines, and most house price measures are still running below year-ago levels.

Household debt burdens are still falling

Most of the recent news has been negative for consumer spending. Income growth has slowed, equity values have declined, and consumer confidence has plummeted. One

of the rare continuing supports for spending is the decline in the household debt service burden. The Federal Reserve calculates the debt service burden as the share of disposable income needed for interest and amortization payments on outstanding mortgage and consumer debt. The 2Q11 figures released this week indicate the ratio declined to 11.1%, its lowest level since 1994, as both outstanding debt and interest rates have been trending lower. The declining debt service burden has added nearly a percentage point to household purchasing power over the past year.

To the extent that falling debt service burdens reflect lower homeownership rates, the benefit to household finances might be overstated. A household that shifts from owning to renting has reduced required debt payments, but it has to pay rent instead. The Fed also estimates another ratio, the financial obligations ratio, that includes required mortgage payments and rent payments (and required car loan payments and lease payments). The financial obligations ratio shows an almost identical trend and has dropped just as much over the past year.


Terry BeltonAC Meera Chandan Kimberly L. Harano J.P. Morgan Securities LLC

10

Treasuries

Even at the ultra-low yields reached this week, the Treasury rally showed no signs of slowing in response to weaker equity markets, indicating that the long duration trade is not at all crowded

While Treasuries are at extremely rich valuations, flows stemming from variable annuity and mortgage hedging suggest the rally could have legs; we look for rates to be biased lower in the near term before retracing later in the year

This week’s massive flattening of the long end is not overdone; Operation Twist and VA hedging needs have lowered the fair value of the 10s/30s curve by over 20 bp

The Fed is likely to buy the WI 7s in size; Buy the WI 7s versus the TYZ1 CTD

With the Fed buying significant amounts in the very long end, we look for the pace of stripping to abate, which should be supportive of Cs versus Ps

Stay neutral on TIPS breakevens

Market views

Long-end Treasury rates plummeted this week with 30-year yields falling 47 bp, 10-year yields falling 27 bp, 5-year yields falling 8 bp, and 2-year yields rising 4 bp. The catalyst for the massive flattening was Operation Twist as the Fed surprised the market by announcing its intention to purchase a much higher fraction of long-end securities than anticipated. This flattening, combined with the sharp sell-off in equities, produced follow-on duration demand from insurance companies and mortgage hedgers. The rally has pushed 10-year yields to 1.81%, 40 bp below long-term inflation expectations in the U.S. and nearly 170 bp below real 10-year rates in Japan (Exhibit 1).

While Treasury rates are at extremely rich valuations by almost any measure, two sets of exposures suggest the rally could have legs as investors are forced to rebalance portfolios in response to this week’s huge move in the long end. First, the combination of a 80 point sell-off in the S&P, and the sharp decline in yields this week has had a significant impact on the duration risk of insurance

companies’ variable annuity (VA) books. Our index of VA hedging needs increased an unusually large $24 bn of 20-year equivalents this week alone and is up $70 bn since late July (Exhibit 2). This represents the biggest move since 4Q08 and suggests a significant need for these institutions to buy long-end duration. Not all of this buying has already occurred, raising the potential of further follow-through especially if equities remain weak.

Second, the massive bull flattening has caused forward rates to fall much faster than spot rates, with 10Yx10Y forward swap rates falling nearly 70 bp thru Thursday this week. These declines have caused the duration of

Exhibit 2: Our index of VA hedging needs suggests a significant need for insurance companies to buy long-end duration Index of variable annuity hedging flows; $bn of 20-year equivalents

150160170180190200210220230240250260

2009 2010 2011

Exhibit 1: The rally has pushed 10-year yields 40 bp below long-term inflation expectations in the U.S. 10-year government bond yields minus 10-year inflation swap rates by country; %

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

Dec 10 Mar 11 Jun 11 Sep 11

USGermanyUKJapan



11

mortgage indices to plunge more than one year as forward looking prepayment speeds accelerate (Exhibit 3). While the rebalancing flows of mortgage servicers and other mortgage hedgers have largely been insensitive to rates this year due to refinancing barriers, duration declines of this magnitude raise the potential of increased duration buying from the mortgage market.

Finally, we note that, even at the ultra-low yields reached this week, the Treasury rally in response to weaker equity markets showed no signs of slowing. Indeed, as intra-day data for Thursday and Friday of this week highlights (Exhibit 4), the sensitivity of rates to equities increased as 10s traded below 1.75%. This indicates the long duration trade is not at all crowded and suggests rates have further room to fall if equities continue to weaken. At some point, the richness of Treasuries and the compression against the zero boundary will cause rates to decouple from equities but this week’s price action suggests we are not there yet.

Given these supportive factors, we have lowered our year-end forecast to 10-year rates to 2.25% (formerly 2.60%). At the same time, our near term bias remains for rates to stay at current levels or move lower (our one month ahead forecast equals 1.70%) before eventually retracing some of the extreme richness of Treasuries (Exhibit 5). To be sure, the catalyst for such a retracement is lacking currently and ultimately will likely require a much larger policy response from the EU and/or fiscal stimulus from

the US before European and US equity markets can stabilize.

Operation Twist and the 10s/30s curve

At this week’s FOMC meeting, the Fed announced its decision to initiate Operation Twist and begin lengthening the duration of its SOMA portfolio. The overall size of the operation was broadly in line with what we had expected and will involve the Fed selling $400bn face value of securities maturing within 3-years and purchasing the same amount in the 6- to 30-year sector. To help support the mortgage market, the Fed also announced it will reinvest Agency debt and MBS redemptions in the MBS market. The schedule of operations for October will be released on September 30.

Exhibit 3: The duration of the mortgage index plunged by more than one year this week, raising the potential of increased duration buying from mortgage hedgers Option adjusted duration of the J.P. Morgan mortgage index; years

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Dec 10 Mar 11 Jun 11 Sep 11

Exhibit 4: The sensitivity of rates to equities increased this week even as 10-year yields made new lows Half-hour changes in 10-year Treasury yields (%) regressed against changes in the S&P 500 (pts) on 9/22/11-9/23/11

-0.04

-0.03

-0.02

-0.01

-0.00

0.01

0.02

0.03

0.04

0.05

-15 -10 -5 0 5 10 15Change in S&P 500; pts

Y = 0.0019 X1 - 0.0000 X1^2 + 0.0036R² = 44.22%standard error = 0.0109

Exhibit 5: J.P. Morgan interest rate forecast%

Actual 1m ahead 4Q11 1Q12 2Q12 3Q1223 Sep 11 23 Oct 11 31 Dec 11 31 Mar 12 30 Jun 12 30 Sep 12

RatesEffective funds rate 0.08 0.08 0.10 0.10 0.12 0.12

3-mo LIBOR 0.36 0.45 0.40 0.40 0.30 0.30

3-month T-bill (bey) 0.00 0.00 0.03 0.03 0.15 0.15

2-yr Treasury 0.22 0.25 0.30 0.30 0.35 0.35

5-yr Treasury 0.85 0.80 1.15 1.30 1.45 1.45

10-yr Treasury 1.81 1.70 2.25 2.60 2.80 2.80

30-yr Treasury 2.87 2.90 3.50 3.80 4.00 4.00

Change to prev. 10y forecast - -0.35 -0.20 -0.20 -0.20



12

The amount announced under Operation Twist will result in sizeable net duration buying by the Fed. Although the exact amount will depend on the specific securities the Fed selects, we estimate net duration buying of Treasuries will equal $53 bn of 10-year equivalents per month (slightly revised from our initial estimates) for a total duration add of $475 bn (Exhibit 6). Although the pace of duration buying was in line with our expectations, the initial impact on intermediate yields, (even controlling for the equity market sell-off), appears to be well above our 10 bp estimate as the flattening rally triggered significant rebalancing flows from both the mortgage market and insurance hedgers.

The biggest surprise in the announcement is the sizeable amount of bonds to be purchased in the very long end of the curve. When the operation is complete, the Fed will own 28% (up from 13%) of outstandings in the 20- to 30-year sector of the curve (Exhibit 7) with total long end purchases of $116 bn or nearly five times the amount it bought during QE2. In response to this, the 10s/30s Treasury curve has flattened 20 bp, representing one of the largest one-week moves in the long end in the last 10 years.

While some of this flattening is technical and may reverse as markets settle down, most of it reflects the more fundamental influence of a sharp reduction in available supply at the long end. Using our fair value model of the 10s/30s yield curve (see grey box), we estimate the long end should have flattened by 12 bp this week due to the supply effects of Operation Twist, and by another 8 bp

Exhibit 6: Operation Twist will result in significant duration buying of Treasuries Projected monthly UST duration buying by the Fed during Operation Twist

Avg. monthly purchases; $bn

of notional

%ge distribution

Avg. monthly purchases; $bn

of 10y equiv.

0.5-3 -44 -100% -9

3-6

6-8 14 32% 11

8-10 14 32% 14

10-20 2 4% 3

20-30 13 29% 31

TIPS 1 3% 2

Total 0 53

Purchase bucket (years)

Operation Twist

Long end supply and the 10s/30s Treasury curve To measure the impact of supply on the Treasury yield curve, we have historically used both stock (i.e. amount outstanding) and flow (issuance) variables in our empirical models of Treasury yields. While both variables work well, the stock model is more appropriate for quantifying the impact of Fed purchase operations on yields. This is because Fed purchase operations reduce net issuance only temporarily, but have a more permanent (until the Fed exits) impact on reducing the amount of debt outstanding. The coefficient on this stock variable should therefore provide a reasonable estimate of the impact of Fed purchases on the yield curve. Exhibit A presents our fair value model of the 10s/30s Treasury yield curve estimated over five years of data. The curve is modeled as a function of 1) the level of short-term Treasury yields, 2) 5Yx5Y forward inflation expectations from the inflation swap market, 3) variable annuity hedging needs and 4) the total amount of outstanding Treasury debt in the 17- to 30-year sector of the curve. All of the variables are highly significant including the Treasury supply variable. The model highlights that the Treasury’s decision to increase long-end supply in 2008 is a key reason why the 10s/30s curve is so steep, with the $350 bn increase in outstandings since then steepening the curve by 31 bp (Exhibit B). Given that Operation Twist will reduce this outstanding amount by $116 bn, we estimate the impact on the 10s/30s curve to be on the order of 10 bp (.116 x .105). The other important variable impacting the curve this week is the duration risk in variable annuity books of insurance companies. These hedging needs increased by $24 bn this week implying an additional 8 bp of flattening (.105 x 24) in the long end of the yield curve. Exhibit A: A fair value model of the 10s/30s Treasury curve

Variable Coefficient T-statisticsIntercept 1.142 17.2

3-year yields; % -0.242 -48.7

5yx5y inflation swap rates; % 0.108 7.3

JPM index of variable annuity hedging flows; $bn of 20-year equivalents

-0.003 -18.3

Treasuries outstanding with maturities greater than 17-years; $tn

0.105 28.7

5-year regression; R2 = 93.4% Exhibit B: 10s/30s Treasury curve (adjusted for other drivers) versus long end Treasury outstandings

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

200 250 300 350 400 450 500 550 600Treasuries outstanding with maturities > 17-years; $bn

Y = 0.001 X1 + 0.108 X2 - 0.003 X3 - 0.242 X4 + 1.142R² = 93.4%standard error = 0.099period = Sep 23,06 - Sep 23,11



13

due to the sharp increase in variable annuity hedging needs as equities sold off and rates fell. Including the impact of the other variables in the model implies the fair value of the 10s/30s curve has fallen by 21 bp, which is virtually identical to the actual move in the curve this week (Exhibit 8). Thus, despite the magnitude of this week’s move, we still expect more back-end flattening as the factors behind it are unlikely to quickly reverse.

In anticipation of Operation Twist, we like the WI 7s more than the 4% Aug-18s. The 4% Aug-18s are the cheapest to deliver (CTD) into December 10-year futures and are thus not eligible to be purchased by the Fed until after December expiry. Moreover, the Fed already owns 61.4% of this issue. The WIs, by contrast, are currently one of the cheapest issues (relative to a fitted curve) in the 6- to 8-year sector, and after they settle at the end of the month, are likely to bought in size by the Fed. Indeed, during QE2, the Fed routinely purchased on-the-run 7s, ramping up its ownership to as much as 25% of the issue size within a month of auction (Exhibit 9). As a result, the on-the-runs typically richened relative to surrounding issues in the days after it was auctioned. This pattern was particularly noticeable when QE2 first started: in the first five months after QE2 began, the on-the-run 7s richened relative to the 10-year futures CTD after each 7-year auction, by an average of 1.1bp. The pattern broke down in the last two months of QE2, likely as it became widely anticipated by market participants.

STRIPS update

Stripping activity has abated in recent months, after accelerating in 2010. Since the beginning of 2011, the amount of P-STRIPS outstanding has increased by only $4bn. By contrast, in 2010, the amount of P-STRIPS outstanding increased by $24bn. While lower yields likely contributed to the slowdown in 2011, another contributing factor was likely the pick up in Fed buying of Treasuries. Exhibit 10 presents a simple model for STRIPS net

Exhibit 7: The Fed will own nearly 30% of the long end when it completes Operation Twist Current and projected* percentage of amount outstanding held by the Fed by maturity bucket; %

16%

39%

16%

33%

13%

2%

31%

36%

28%

38%

0%

10%

20%

30%

40%

50%

0.25-3 6-8 8-10 10-20 20-30

Currently held by FedProjected

Maturity buckets; y ears

* Assumes that purchases occur in line with that specified by the Fed. Projections are shown for 6/30/12.

Exhibit 9: WI 7s will likely richen versus TYZ1 CTD as Operation Twist begins Percentage of on-the-run 7s held by the Fed (%) versus the yield curve between the on-the-run 7s and the rolling front TY CTD (bp) averaged over the business days after the 7-year auctions; December 2010 - May 2011 % %

10.2

10.3

10.4

10.5

10.6

10.7

10.8

10.9

11.0 0

5

10

15

20

25

0 2 4 6 8 10 12 14 16Business days after the 7-year auction

On-the-run 7s/ TY curve (inverted)Percentage held by Fed

Exhibit 8: Twist and VA hedging lowered the fair value of the 10s/30s curve by 20 bp this week Actual versus model* 10s/30s curve; %

1.00

1.05

1.10

1.15

1.20

1.25

1.30

1.35

1.40

1.45

1.50

Jul 11 Aug 11 Sep 11

ActualModel

* 10s/30s Treasury yield curve modeled as 1.142 – 0.242 * 3-year yields (%) + 0.108 * 5yx5y inflation swap rates (%) -0.003 * JPM index of VA hedging flows ($bn of 20-year equivalents) + 0.105 * Treasuries outstanding in the 17- to 30-year bucket ($tn)



14

“issuance” and shows that higher rates and a steeper curve have typically resulted in more net stripping. Notably, the model also shows that an increase in Fed purchases of Treasuries have tended to lower net stripping, as it takes out supply from the Treasury market and thus results in greater reconstitutions.

Looking ahead, we look for net stripping activity to stay muted and for reconstitutions to increase. The primary motivation for our view is the beginning of Operation Twist, which will take out significant amounts of long-end supply. Demand for STRIPS has been concentrated in the very long end as well: currently, the 20- to 30-year sector comprises 59% of all P-STRIPS outstanding. Notably, several issues in this sector that have been stripped the most also appear cheap on the curve on a yield-error basis (Exhibit 11). The May-40s and Nov-39s in particular stand out in this regard. Since the Fed has historically preferred to purchase securities with high yield errors, these issues are likely candidates for reconstitution in the coming months.

One implication of higher reconstitution activity, particularly in longer-maturity P-STRIPS, is that the supply of short-dated C-STRIPS is likely to decline since C-STRIPS must be used up in the reconstitution process. This has historically tended to richen short-dated C-STRIPS versus similar-maturity P-STRIPS, as shown in Exhibit 12. Looking ahead, we expect a similar trend to materialize and look for shorter-dated C-STRIPS to richen versus maturity-matched P-STRIPS. In particular, we like Nov-21 Cs more than matched-maturity Ps. Not only is the C-P spread in this sector close to its highs since January 2009 (Exhibit 12), but a reconstitution of Nov-39s or May-40s in line with our expectations will also be supportive of this trade, if realized

TIPS

TIPS were crushed in the risk-off trade over the past week, as oil prices tumbled 7% and 10-year nominal yields fell 27bp. On Thursday, the 10-year TIPS reopening attracted record end-user demand despite all-time low yields at auction, with direct bidders taking down 36% of the issue and indirect bidders taking down 30% (Exhibit 13). However, the issue still came with a modest tail, and 10-year breakevens narrowed 17bp on the day on the back

Exhibit 12: The spread between C- and P-STRIPS is currently at its highest level since January 2009, partially driven by greater stripping activity Coupon minus Principal STRIPS yield spread in the 2022-23 sector* (bp) versus the total amount of P-STRIPS outstanding ($bn)

1

2

3

4

5

6

7

8

170

175

180

185

190

195

200

205

210

2010 2011

Average C-P spreads; bpP-STRIPS outstanding; $bn

* Average C-P spread between issues maturing on 8/15/22, 11/15/22, 2/15/23 and 8/15/23.

Exhibit 10: A pick up in Fed purchases has historically lowered stripping activity A model for quarterly changes in P-STRIPS outstanding; $bn

Variable Coefficient T-statisticsIntercept -47.0 -3.0

Quarterly change in S&P 500; pts 0.022 1.9

10-year Treasury rates; % 9.2 2.9

10s/30s curve; % 21.2 3.2

Quarterly Fed purchases of Tsy; $bn -0.02 -1.2 Model fitted for quarterly data over a 5-year period. R2= 57%. 10-year Treasury rates and the 10s/30s curve are quarterly averages.

Exhibit 11: Several issues in the very long-end that have been stripped the most also have the highest yield errors, making them attractive candidates for reconstitutions Amount stripped ($bn) regressed against the yield error of the issue (bp) of bonds outstanding in the 20- to 30-year sector

A-41M-41

F-41N-40

A-40

M-40

F-40 N-39

A-39

M-39

F-39M-38

F-38M-37

F-37

F-36

0

5

10

15

20

25

-1 -0.5 0 0.5

Yield error; bp



15

of the massive risk-off trade. Although breakevens retraced somewhat on Friday, they still ended the week sharply narrower: 5-, 10-, 20- and 30-year breakevens narrowed 27bp, 22bp, 29bp, and 32bp, respectively.

Looking ahead, we remain neutral on TIPS breakevens. On one hand, TIPS breakevens look extremely narrow relative to nominal rates, oil, and our economic surprise index (Exhibit 14). In addition, on the margin, lower effective net issuance of TIPS due to Fed purchases under Operation Twist is supportive of TIPS. On the other hand, with nominal yields likely to decline in the near term, and with increased risk aversion likely to weigh both on oil prices and TIPS, we think TIPS breakevens may continue to decline over the near term. Moreover, from a medium-term perspective, our economists expect inflation to decline from its current elevated level now that commodity prices have eased and the dollar has strengthened (see Economics). Thus, given these offsetting factors, we stay neutral on breakevens.

Across the curve, we think 5-year and 10-year breakevens are most vulnerable to further underperformance. Five-year breakevens have the greatest exposure to both oil prices and nominal rates and are not eligible for the Fed’s purchase operations, while 10-year breakevens are vulnerable if 10-year nominal rates continue to decline as we expect. On the other hand, 30-year breakevens are less exposed to these factors and appear to be the cheapest point on the curve.

Operation Twist and TIPS

On Wednesday, the Federal Reserve Bank of New York announced that it would concentrate 3% of its purchases in TIPS as part of its $400bn Operation Twist program. As Exhibit 15 shows, Fed purchases under Operation Twist will lower effective net issuance in 2H11 and 1H12, but the pace of net issuance will remain well above what was seen in 1H11.

There has been some discussion as to whether the Fed will sell front-end TIPS as part of Operation Twist. Although the Fed has made no indication that TIPS will be excluded from sales operations, we do think sales of front-end TIPS will likely be limited. As Exhibit 16 shows, not only are the Fed’s holdings of TIPS issues in the 3-month to 3-year sector substantially smaller than in the nominal universe, but the Fed also tends to hold a smaller amount of each

Exhibit 13: Despite the all-time low yield at auction, 10-year TIPS attracted record end-user demand Statistics for 10-year TIPS auctions; units as indicated

Auction date

Size

($bn)

BE before

auction (bp)

Yield before

auction (% )

Bid/

cover

Primary

dealer %

Direct

bidder %

Indirect

bidder %

Tail

(bp)

01/06/09 8 12.6 2.312 2.48 40% 13% 47% -10.0

04/07/09 (re) 6 145.3 1.485 2.25 72% 2% 26% 2.6

07/06/09 8 165.3 1.848 2.51 46% 5% 50% -1.0

10/05/09 (re) 7 169.7 1.521 3.12 56% 0% 44% -4.0

01/11/10 10 244.2 1.352 2.65 56% 3% 41% -0.8

04/05/10 (re) 8 226.5 1.681 3.43 55% 8% 37% -4.1

07/08/10 12 173.2 1.242 2.88 44% 4% 52% -3.0

09/02/10 (re) 10 158.4 0.997 2.80 51% 3% 47% 0.0

11/04/10 (re) 10 217.0 0.452 2.91 40% 2% 58% 4.5

01/20/11 13 235.8 0.931 2.37 59% 3% 38% 6.0

03/24/11 (re) 11 238.9 0.958 2.97 68% 7% 25% -4.5

05/19/11 (re) 11 236.2 0.770 2.66 56% 3% 41% 1.0

07/21/11 13 232.4 0.553 2.62 45% 14% 42% -3.1

Average 188.9 1.239 2.74 53% 5% 42% -1.3

09/22/11 11 197.6 0.097 2.61 34% 36% 30% 1.8

Exhibit 15: Fed purchases under Operation Twist will modestly lower effective net issuance of TIPS Gross issuance (actual and forecast), redemptions, Fed purchases*, and effective net issuance; $bn of real principal

Gross

issuance Redemptions

Fed

purchases*

Effective net

issuance

2007 57 15.8 41.2

2008 56 16.8 39.2

2009 58 15.9 4.6 37.5

2010 86 39.3 6.4 40.2

1H11 65 31.2 19.0 14.8

2H11 E 66 0.0 5.3 60.7

1H12 E 66 23.3 8.0 34.7

* Assumes $0.4bn of purchases next week and assumes that Operation Twist purchases are evenly distributed over October 2011-June 2012.

Exhibit 14: TIPS breakevens look extremely narrow versus nominal rates, oil, and economic data Statistics for breakevens regressed against nominal yields, rolling front Brent crude oil futures and the EASI index; past one year

5Y BE 10Y BE 30Y BENominal rates beta 35.51 27.80 25.55

T-stat 24.5 23.2 14.3

Oil beta 1.60 0.73 0.28

T-stat 24.4 12.7 3.9

EASI beta -0.03 0.01 0.02

T-stat -0.5 0.2 0.2

Intercept -38.77 67.52 116.16

R-sq 90% 81% 51%

Standard error (bp) 9.8 8.7 11.0

Current level (bp) 135.6 175.7 189.4

Residual (bp) -21.6 -18.1 -29.0



16

TIPS issue. Furthermore, a smaller fraction of the Fed’s overall TIPS holdings is concentrated in the front end compared to its nominal Treasury holdings. Thus, we expect the Fed to sell only a modest amount of TIPS, likely only a fraction of the $12bn it is projected to buy.

Exhibit 17 presents statistics for the eight TIPS issues in the 3-month to 3-year bucket. On the margin, we think the Fed will likely favor selling rich issues that it holds larger amounts of.

Exhibit 16: Front-end securities make up a much smaller fraction of the Fed’s TIPS holdings compared to its nominal Treasury holdings Statistics for the front-end TIPS and nominal Treasuries in the Fed’s SOMA portfolio

# of issues

in 3M-3Y

bucket

Total holdings in

3M-3Y bucket

($bn)

Avg holdings

size per issue

($bn)

Avg

holdings %

per issue

Short end as

% of total

holdings

TIPS 8 11 1.4 7.5% 17%

Nominals 95 498 5.2 17.5% 32% Source: Federal Reserve Bank of New York Note: Issues with maturities ranging from 1/15/12-9/30/14 were included.

Exhibit 17: Statistics for front-end TIPS Statistics for TIPS in the 3-month to 3-year sector; units as marked

Cpn Maturity

Fed holdings ($bn

of real not'l)

Fed holdings

(% )

Yield error

(bp)

3.375 01/15/12 0.1 1.5% 140

2.000 04/15/12 3.3 19.0% 84

3.000 07/15/12 2.9 12.4% 8

0.625 04/15/13 1.0 6.7% -5

1.875 07/15/13 1.6 7.9% -15

2.000 01/15/14 1.5 7.3% -26

1.250 04/15/14 0.3 1.8% -17

2.000 07/15/14 0.6 3.0% -19

Source: Federal Reserve Bank of New York, J.P. Morgan


Meera ChandanAC Renee Park J.P. Morgan Securities LLC

17

Agencies

Despite cheap valuations of Agency spreads versus Treasuries, given seasonality trends and continued exogenous risks stemming from Europe…

…we stay neutral on Agencies versus Treasuries

Market views

Over the past week, initially the performance of Agencies was relatively little changed versus Treasuries before cheapening in the days following the release of the September FOMC statement. With the exception of the front end, Agencies ended the week significantly cheaper versus Treasuries: 5- and 20-year Agencies cheapened by 5bp and 9bp, respectively, while 2-year Agencies richened by 0.5bp. On the other hand, Agencies broadly cheapened versus swaps across the curve with 2-, 5-, and 20-year Agencies cheapening by 1.5bp, 7.5bp, and 10.5bp, respectively. A large portion of the cheapening move by Agencies versus both Treasuries and swaps during the latter half of the week followed the FOMC statement, which announced Operation Twist to the tune of $400bn, as well as the decision to change its reinvestment policy such that Agency debt and MBS will be reinvested into Agency MBS rather than Treasuries, starting October 3. We view the FOMC statement as a negative for long-end Agency debt, but expect demand for Agency debt to remain elevated since investors seeking additional yield pickup in the current yield-starved environment will likely replace Treasuries with Agencies. Also helping the widening of Agency spreads versus Treasuries this week was the influx of $4bn of bellwether supply: FNMA re-opened $1bn of an existing 5-year Benchmark Note and issued $3bn of a new 3-year Benchmark Note. Five-year Agencies versus Treasuries are now 6bp wider versus fair value on the week, and are near historically cheap levels (Exhibit 1). However, notwithstanding this wideness of Agency spreads relative to our fair value estimates, we stay neutral on Agencies versus Treasuries. Under normal market conditions, we would expect residuals in our fair value model to mean-revert to

zero, and thus the current wide residual would point to an overweight in Agencies versus Treasuries. However, seasonal quarter-end trends, as well as the European crisis, will likely keep spreads wide. Seasonally, 2- and 5-year Agency spreads versus Treasuries have widened over the 2-week period following third quarter-end. In 7 out of the past 11 years, 2-year Agency spreads versus Treasuries have widened over this period by an average

Exhibit 1: The residual of our fair model is at 30-month highs Residual* of J.P. Morgan model of 5-year Agency spreads to Treasuries (bp)

-30

-25

-20

-15

-10

-5

0

5

10

15

20

Sep 09 Mar 10 Sep 10 Mar 11 Sep 11

* Residual modeled as actual spreads minus (20.88 * 18m forward, 1m OIS rate minus the 6m forward, 1m OIS rate) – (0.65 * 3-month change in central bank custody holdings of Agency debt, adjusted for MBS) + (0.19 * 3-month change in FNMA and FHLMC bullet debt outstanding) – (0.23 * 4s/5s/6s Treasury butterfly spread to 4s/5s/6s swaps butterfly using hot-run 5-year yields and par 4- and 6-year yields) + (0.058 * 1-week moving average of 1-year ahead budget surplus expectations).

Exhibit 2: Historically, Agency spreads versus Treasuries have widened heading out of the third quarter 2-year Agency z-spread to Treasury (bp) and 5-year Agency z-spread to Treasury; from 2000-2010, around the third quarter-end of each year bp bp

30

31

32

33

34

35

36

-10 -8 -6 -4 -2 0 2 4 6 8 10

43

44

45

46

47

48

2-year

5-year

Business days around third quarter-end


Meera ChandanAC Renee Park J.P. Morgan Securities LLC

18

of 6.4bp; and in 7 out of the past 11 years, 5-year Agency spreads versus Treasuries have widened by an average of 4.3bp (Exhibit 2). Furthermore, the steady escalation overseas of the European crisis has had the side effect of deterring mean reversion to fair value in Agency spreads. This is evident by looking at Agency valuations in the following manner. A regression of 1-month changes in 5-year Agency spread to Treasuries versus the ex-ante level of a crisis proxy (in this case, we use the 5-year CDS spreads of several French banks) and versus the ex-ante level of our model residual produces a positive coefficient in the first variable (crisis proxy) and a negative coefficient in the latter variable (model residual of Agency spread versus Treasuries). We exclude August and September from this regression given the unusual market conditions in these months that were driven by other factors outside of the European crisis (Exhibit 3). In this regression, the positive coefficient on the crisis proxy variable indicates that the mean reversion in 5-year Agency spreads versus Treasuries is deterred by elevated exogenous risks from the European crisis. Moreover, if we use the current level of the residual, as well as the current level of our crisis proxy variable, this model suggests that mean reversion to fair value is not to be expected in the near term.

Therefore, we stay neutral on Agency spreads versus Treasuries. Additionally, we continue to like short-dated callables with 2-year final maturity versus maturity-matched bullets. For instance, the yield pickup in 2nc6m European callables versus maturity-matched bullets remains closer to the upper end of its recent range (Exhibit 4). Thus, we continue to prefer carry trades expressed in the 2-year sector and we like exposure to 2-year European callables versus maturity-matched bullets.

Exhibit 3: Despite being wide to fair value, Agency spreads versus Treasuries are unlikely to mean-revert due to the elevated level of exogenous risks stemming from the European crisis One-month change in 5-year Agency par spread to Treasuries (bp) regressed against an ex-ante crisis proxy* (bp) and ex-ante residual of the J.P. Morgan model** of 5-year Agency spread to Treasuries (%), regression over 7 months

-15

-10

-5

0

5

10

15

90 100 110 120 130 140 150 160 170 180Ex-ante crisis proxy* (bp)

Y = 0.1590 X1 - 0.6933 X2 - 19.3892R² = 26.15%standard error = 3.9062period = Dec 31,10 - Jul 31,11

* 1-month lagged average of 5-year CDS spreads of BNP Paribas, Société Générale, and Crédit Agricole. ** See footnote on residual in Exhibit 1.

Exhibit 4: The spread pick of 2-year final maturity Agency European callables versus maturity-matched bullets remains in the higher end of its recent range 2nc6m European callable yield – par 2-year Agency yield (bp)

-5

0

5

10

15

20

Sep 10 Dec 10 Mar 11 Jun 11 Sep 11

High Grade Strategy US Fixed Income Weekly September 26, 2011

Eric BeinsteinAC Dominique D. Toublan Miroslav Skovajsa Anna Cherepanova J.P. Morgan Securities LLC

19

Corporates

US equities are catching up to the negative message from credit markets over the past few weeks

The consensus forecast that the US and Europe will avoid recession looks increasingly optimistic but HG credit spreads are already near recession levels; we believe though that the spreads are not wide enough to reflect a recession plus significant event risk in Europe. Lower Treasury yields will keep upward pressure on spreads, but the spread pick-up over Treasuries and lack of alternatives will require investors to buy despite yields below their targets

So far there is little evidence that HG bond investors have reduced credit exposure recently or intend to, but if the recent underperformance versus Treasuries leads to unwinds, spreads would likely widen much further given the liquidity situation and generally overweight credit position of many aggregate-based managers

Markets are now rightly questioning the assumption that the US and Europe can avoid recession despite fiscal retrenchment, political dysfunction and lack of effective monetary policy options. HG credit spreads had already been pricing in significant recession risk but we would argue that stocks have not. Even now with the S&P down just 10.2% YTD despite growth expectations for the US at 1% or less, (versus 3.5% in January) it appears stocks remain optimistic. European stocks are down 28.5% YTD. It is interesting that it took the Fed’s statement, which highlighted the significant downside growth risks, to cause this latest sell-off. Instead one might have thought the significantly negative economic news reported last week should have driven the sell-off. The silver lining is that recent market weakness will likely accelerate further discussions among policy makers, particularly in Europe over bank capital and support for Greece. In the US, Democrats and Republicans hold such divergent views on the causes and best solutions for weak growth that weaker markets are unlikely to break the paralysis. Despite more policy talk, growing recession risks are going to increase the event

risk issues in Europe around sovereign debt, and earnings concerns heading into the 3Q earnings seasons. We remain with an underweight view on HG credit spreads.

Equity is catching up to the negative view from credit markets. Over the past few weeks credit has underperformed stocks. At the end of this week stocks narrowed this gap somewhat with a significant underperformance on Thursday. The risk-off sentiment has increased, with significant weakness in EM currencies, EM credit and commodities. In this environment it is no surprise that the correlation between asset classes has increased.

Exhibit 1: Equities look to be catching up to the negative view from the credit markets

y = -0.1805x + 337.49

R2 = 0.7724

80

90

100

110

120

130

140

150

1,100 1,150 1,200 1,250 1,300 1,350

CDX.IG

S&P500

3M regression

Source: J.P. Morgan

Exhibit 2: The risk-off trade is leading to rapid spread widening in other asset classes including EM sovereigns (EMBI) which, like HG credit, have strong fundamentals and technicals

120

170

220

270

320


JULI spread

EM BIG IG spreadCEM BI IG spread

bp

Source: J.P. Morgan.



20

Spreads are moving closer to our YE target of 250bp (they ended Wednesday at 227bp) and Treasury yields are falling so rapidly that further declines become less likely. The decline in equity prices also reduces the risk of further declines. These are the trends which will bring us to levels that warrant a less negative view. However, we are not there yet.

Lower Treasury yields will keep upward pressure on spreads, but it is unlikely that spreads will widen enough to offset the fall in Treasury yields. Many investors express frustration at the low level of bond yields. Current low yields are challenging for certain insurance products. Several times over the past few years investors have balked at buying bonds at low yields, only to capitulate when cash balances grew and it became clear that the low yield levels would persist. The increase in recession risks and the Fed’s Operation Twist suggest low long end yields may be persistent once again. Investor cash balances are likely increasing as issuance MTD at $51bn is below expectations, and investors already reported high cash balances heading into the month. We therefore expect that the recent fall in the index yield will not be fully offset by wider spreads in the near term.

This week there was little new news out of Europe.

The EU/IMF/ECB Troika returns to Athens next week to decide on the disbursement of the next tranche of funding. We do expect they will agree to the EUR8bn disbursement in response to further fiscal retrenchment which is being implemented in Greece. As we await news on this it is interesting to think about the comparisons to Argentina in 2001.

If history is any guide, IMF funding can stop abruptly. In May 2001 Argentina was under an IMF program and was under review to determine if they were in compliance for a quarterly disbursement of $1.2 billion. At that time, the key metrics in Argentina that the IMF was looking at were the budget deficit and capital flight from banks. The actual results of the May 2001 review were not in line with the IMF program, but the government proposed tax reforms and a voluntary debt exchange to extend maturities which allowed the IMF to disburse the payment on time. Greece is also perusing a voluntary debt exchange and tax reform. In Argentina after May 2001, the situation subsequently deteriorated with the

Exhibit 4: Dealer positions in corporate bonds is at a multi-year low after falling recently

507090

110130150170190210230250

Jan

05

Sep

05

May

06

Jan

07

Sep

07

May

08

Jan

09

Sep

09

May

10

Jan

11

Sep

11

Primary Dealer Positions - monthly av g$bn

Current = $65bn

Prev ious low

(Apr '09)

=$68bn


Exhibit 3: 30-year bond yields reached a new record low on Wednesday

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

JULI 30Y y ield%

Current:

5.01%


Exhibit 5: CDX.IG trading volumes have significantly increased, especially in August as investors bought protection rather than selling bonds

$14

$18

$10 $11

$21$18

$36

$20

$12

0

5

10

15

20

25

30

35

40


Avg CDX.IG trading vo lume$bn




21

budget deficit rising due to the need to consolidate deficits in Argentine provinces. The IMF agreed to further disbursements for Argentina including $5bn in September 2001 to support this effort. Deposit flight continued, however, which led to imposition of restrictions on deposit withdrawals. In December 2001, the IMF review in Argentina was unsatisfactory and the IMF withheld that disbursement. The country then defaulted on its debt and within one month, with the banking system paralyzed, the Argentine peso had devalued by almost 30%, and ultimately to a peak depreciation of 75% in the course of the next six months.

There are many differences between the situation in Argentina 10 years ago and Greece today. Argentina was trying to defend a fixed exchange rate while Greece with the euro does not have this challenge directly. Of course Greece has the EU support, in addition to the IMF. The broader comparison is valid from some angles, however. Argentina was trying to defend an exchange rate which the population felt was unsustainable, hence the capital flight. Greece is trying to defend its ability to support a debt burden which most believe is unsustainable. In both cases the IMF is/was caught stretching its credibility by setting terms that the countries did/do not meet, but then disbursing funds anyway on the back of promises of further reform. The IMF did this a couple of times in Argentina before stopping. In Greece, it looks as if this next payment will be disbursed. The economy will continue to contract, however, making the promises of greater fiscal austerity difficult to achieve, and likely leading to another period of uncertainty when the next IMF review comes due later in the year.

Lower liquidity and negative returns in August are contributing to HG bond spread volatility in September

Recent volatility has been exaggerated by light positions by dealers and cautious behavior from investors driven by credit losses. On the dealer side, the most recent data from the NY Fed indicates that dealer positions in corporate bonds have reached an 8-year low of $65bn on September 1. The previous monthly average low was in April 2009, with $68bn corporates held on dealer balance sheets. Furthermore, the overall market size is larger today than in 2009. In relative terms, therefore, current dealer positions are at multi-year lows.

Investors have tended to be quite defensive as well, generally adding to positions only in the higher rated non-cyclical sectors. Part of this defensiveness is driven by the very low -3.7% excess returns registered in August. This is the lowest monthly excess return since September 2008. QTD excess return is even lower at -5.0%. August total return was also low at 0.3%.

However, we believe investors have not generally reduced their positions but some have hedged using CDX.IG. This is true even in Financials, despite their underperformance. Altogether, this has resulted in low

Exhibit 8: JULI bank average ratings have declined even more than the overall index ratings

US Banks Jan-07 Last week Now

AAA 0% 0% 0%

AA 41% 5% 5%

A 55% 85% 69%

BBB 4% 10% 26% Source: J.P. Morgan.

Exhibit 6: BAC spread before Wednesday’s downgrade was already quite wide relative to an average BBB-rated Industrial company

0

50

100

150

200

250

300

350

400

WFC JPM C GS MS BAC

bp, Tsy

AAA AAA BBB

Source: J.P. Morgan, grey is the average spread of non-financials with these ratings.

Exhibit 7: JULI average ratings have fallen with this week’s bank downgrades

JULI Jan-07 Last week Now

AAA 4% 1% 1%

AA 18% 13% 13%

A 42% 47% 45%

BBB 36% 39% 41% Source: J.P. Morgan.



22

trading volumes in High Grade bonds, as shown in the Exhibit below. So far in 3Q11, the daily trading volume of HG bonds has represented about 0.27% of the principal outstanding. This is equal to 3Q10 and only slightly higher than the lowest turnover ever seen in 3Q08 (0.26% of the market trading per day). Overall, the average YTD trading volume is 0.29% of the market, smaller than in 2010 (0.30%) and much smaller than the 0.41% seen in 2006 before the crisis.

Instead of selling bonds, investors have hedged their existing positions using CDX.IG. As a consequence, trading volumes have significantly increased in CDX during the year. The largest trading volumes were actually seen in August when the bulk of the HG bond market sell-off took place.

Bank spreads were already trading very wide to ratings before recent downgrades, so the large sell-off on the ratings downgrade is somewhat puzzling

Kabir Caprihan published a note last night discussing the bank rating downgrades. Moody’s concluded its review of the large banks, and now its ratings assume that likely government support in the event of stress is worth two rating notches for Bank of America and Citigroup but only one notch for Wells Fargo. We believe the impact from these downgrades will be limited given that the agencies had essentially telegraphed the move for over 12 months, giving the banks plenty of time to reduce reliance on short-term funding. While we had expected the agency to reduce the support by two notches, we had been looking for the agency to increase Bank of America’s stand-alone rating by one notch, which would have resulted in only a one-notch downgrade in the long-term ratings.

The ratings downgrade contributed to spread weakness in the impacted banks, especially BAC. While this is not a surprise as it was negative news, the sell-off does seem surprising for two reasons. First, the downgrades were widely expected. Second, spread on the impacted banks before the downgrade were already well above that of similarly rated companies. It is as if the markets were not giving the banks credit for their ratings versus other companies before the downgrade (as they traded wide already) but penalized the spreads when the downgrades occurred anyway. The exhibit below illustrates the current spread for the large US banks and how that

spread compares to other companies with the same rating. The exhibit highlights both how wide the bank spreads are for their ratings, and how divergent the spreads of similarly rated banks are trading.

HG Bond index average ratings negatively impacted by this week’s bank downgrades

Moody’s downgrade of BofA has implications for the ratings distribution of the HG bond market. Recall that an issuer-assigned rating in JULI is the worst of Standard & Poor’s and Moody’s ratings. About $80bn of index eligible bonds were downgraded by two notches yesterday. All but a few OpCo, BofA, and Merrill bonds are now BBB versus A previously. The affected bonds comprise 2% of the market, resulting in the A share falling to 45% from 47% and the BBB share growing to 41% from 39% (Exhibit 7). The impact is much larger on the US Bank sector, where the downgraded bonds account for 16% of the sector. US Bank A shares fell to 69% from 85%, while BBB shares increased to 26% from 10% (Exhibit 8).


Peter DeGrootAC Josh Rudolph J.P. Morgan Securities LLC

23

Municipals

This week’s move to lower rates will attract inflows and further support spread product

Investors who hold longer-dated BABs and pay above a 14% marginal effective tax rate should consider selling BABs and purchasing similarly rated tax-exempt bonds for sizable gains in taxable equivalent yield

Certain established toll roads can offer more than 100bp of credit spread despite manageable leverage, tight flows of funds, ample liquidity, strong demographics and independent toll-setting regimes

Rates plummet on decisive Fed action and indecisive European policy; muni funds reap the benefits of strong performance

Implications of the move lower in yields This week, 10-year and 30-year Treasury yields fell by 23bp and 41bp while high-grade municipals yields dropped ‘just’ 16bp, and 26bp, respectively. We believe the Fed’s $400bn twist accounted for much of the dramatic movement in the 30-year portion of the curve as the 29% proportional allocation caught the market by surprise. We believe the Fed operation was well telegraphed and largely priced into the 10-year portion of the curve. We expect most of the move in 10-year Treasuries was a result of the risk-off trade sparked by indecision on the part of European leaders regarding the release of the next tranche of capital due to Greece and the Fed’s decidedly grim view of the economy (see Economics). By contrast, the larger movement in 20- to 30-year Treasuries was more directly a function of surprisingly high capital allocation to the longer portion of the curve and, as such, will give back less when the flight-to-quality sentiment ebbs. We expect the recent sizable move down in yields will impact the municipal market in a number of ways over the immediate and long-term. First, in the short run, lower yields result in better returns and attract capital in the fund space (Exhibit 1). Over the past three

weeks cumulatively, in addition to capital flowing into intermediates ($180mn) and high yield ($302mn), long-end funds have also received new capital for the first time this year ($125mn over the past two weeks). It is not a coincidence that the long end of the market has rallied harder than any other point on the curve. We expect long-term funds will sustain inflows over the near term. The low yield environment will also motivate additional support for spread product particularly inside of 15 years on the curve where the roll down is amplified and rate risk diminished versus longer-dated bonds. The longer term outlook is obscured by the prospect of a risk-on again trade as some portion of the fight-to-quality trade is reversed and yields stabilize at new historic lows. The impact on fund flows will be governed by the magnitude of the yield change. Should yields flat-line at current levels, demand become slack, reflecting the unimpressive rates. The lower and flatter curve will also instigate more refunding supply through year-end. The increase in supply will be governed by the fact that the vast majority of refunding candidates have already been executed, given that we have been in this low rate environment for the better part of the past two years. That said, issuers who were waiting for a flatter curve to mitigate negative arbitrage may be motivated to come to market. Exhibit 2 illustrates our supply forecast.

Exhibit 1: Fund flows were positive across the board again$ mn

Fund flows Fund AssetsType of funds Actual 4-wk. avg. Actual 4-wk. avg.All term muni funds 296 70 489,324 487,268New York -7 -15 31,899 31,715California 6 -18 46,148 45,921National funds 321 135 332,310 330,992High Yield 119 49 46,374 46,052Intermediate 62 26 113,260 112,886Long Term 54 -132 284,565 283,182Tax-exempt money market -2,444 -1,236 290,909 293,838Taxable money market -13,504 -2,562 2,302,479 2,316,225Taxable Fixed Income 2,906 715 2,938,676 2,950,660Equity -1,648 -1,100 5,322,390 5,467,670

Source: Lipper US Fund Flows, iMoneyNet Note: The figures shown on this table represent funds that report on a weekly and monthly basis



24

Update on supply This week, supply surged to $8.6bn or the second largest week of the year (Exhibit 3). The rally in the rates markets helped to clean up excess street inventory as tax-exempts cheapened broadly versus Treasuries and alternative taxable spread product. The week’s largest deal, $1.3bn of CA state GO, cleared the market at tighter levels with 10-year bonds pricing at 3.17% and the 30-year a 4.80% yield. Next week’s supply is expected to be about $8bn. The three largest deals will be from the Empire State, including $1bn of taxable Port Authority bonds (Aa2/AA-/AA-), $607mn Triborough Bridge & Tunnel bonds (Aa2/AA-/AA-), and $585bn state GOs (Aa2/AA/AA). Tax-exempts are very attractive relative to taxables At current levels, the tax-exempt market is attractively priced in comparison to alternative taxable fixed income investments in general and taxable municipals more specifically. We expect that next week will see a healthy bid from crossover investors interested in relative price gains, high taxable equivalent yields, and finding high-quality longer duration assets. Tax-exempt bonds offer compelling value relative to Treasury bonds and Libor, as is typically the case when the rates market achieves new lows. The 10-year high-grade is trading 3.4 standard deviations from its 1-year mean and over nine ratios cheap versus the value suggested by the 2-year regression of the ratio to the 10-year Treasury yield (Exhibit 4). The relationship between tax-exempt yields and corporate bonds yields is less consistent with 10-year high-quality tax-exempt bonds trading at relatively rich levels and A and BBB categories trading at cheaper valuations versus their corporate counterparts (Exhibit 4). Tax-exempts produce strong taxable equivalent yields versus similar structure BABs The muted move in tax-exempt yields has resulted in a dislocation in the relative value between tax-exempts and taxable municipal bond markets. Investors who hold longer-dated BABs and pay above a 14% marginal effective tax rate would benefit from selling BABs and purchasing similar rated tax-exempt bonds. At a 30% marginal effect tax-rate, an investor would earn approximately 100bp higher taxable equivalent yield by

Exhibit 2: Issuance is expected to tick up in 4QQuarterly municipal bond issuance, $ bn

0

50

100

150

1Q07 1Q08 1Q09 1Q10 1Q11

JPM forecastNew moneyAdvance refundingsCurrent refundings

2007 2009 20112008 2010

$260bn

Note: Excludes forward refundings and series that are a combination of new money and refunding Source: Thomson SDC

Exhibit 3: This was the second highest week of tax-exempt supply this year Weekly municipal bond issuance ($ bn)

0

5

10

15Tax-exempt

Taxable

This week

20112010

J J A S O N D J F M A M J J A

*

*

* *

*

*

** *

*

*

S

*

Next week

* Holidays Source: Bloomberg CDRA

Exhibit 4: Tax-exempts are exceptionally cheap versus taxable fixed income Tax exempt/taxable yield ratio (%)

AAA t.e. yld / UST yld (%) Z-scoreLast Min Max MeanSt. Dev. 3mo 12mo

2yr 160.2 85.5 211.7 132.5 30.8 0.9 2.05yr 116.7 71.1 116.7 89.3 10.6 2.6 2.910yr 114.9 86.3 114.9 97.6 7.5 2.3 3.430yr 123.5 98.4 123.5 106.2 5.4 3.2 4.6

Corporate yld - t.e. yld (bp) Z-scoreLast Min Max MeanSt. Dev. 3mo 12mo

AAA 61.4 41.0 121.0 79.5 16.3 -1.1 -1.2AA 119.3 106.7 151.7 130.1 9.5 -1.1 -0.4A 89.7 59.5 117.5 81.9 13.2 0.6 1.1BBB 20.2 -21.8 33.5 9.6 12.7 0.8 0.9

Source: Thomson MMD, J.P. Morgan



25

holding a tax-exempt bond versus a AA-rated BAB (Exhibit 5) and 120bp higher taxable equivalent yield for longer dated A-rated tax-exempts (Exhibit 6). In a large liquid credit such as CA state GO, the taxable equivalent pick-up is 100bp in the 30-year spot on the curve (Exhibit 7). The increased tax adjusted returns are mitigated by the 10-year call option on the majority of longer dated tax-exempts and, to some degree, risk to marginalized value of the tax-exemption. We expect insurance and pension fund demand for longer-dated BABs will improve as the Fed purchase program proceeds. The increasing scarcity of longer-dated Treasury bonds and lack of a new issue BABs will amplify the need for higher-quality longer-dated BABs in the secondary. Established toll roads: Buy inelasticity

We view established toll roads as a relatively attractive sector in the current environment of such low rates and partisan politics. Mention “toll road credit risk” and investors are overcome by images of new highways that never attracted enough drivers and ended in default. Examples of start-up defaults include Connector 2000, Dulles Greenway, the Garcon Point Bridge in FL, the South Bay Expressway in San Diego, and San Joaquin Hills in Orange County. Because of this broad-based stigma, even a strong AA-rated established toll road credit can offer more than 100bp in excess of a AAA-rated GO credit. One reason why start-up toll roads such as the five mentioned above defaulted is that it is very difficult to model commuters’ driving patterns. Such forecasts are

highly complex, first employing sophisticated network models to predict how traffic patterns will evolve such that the new start-up road will save time for potential drivers, and then making judgments about how much drivers value their own time. The difficulty in modeling such behaviors has led many forecasts commissioned to support start-up toll roads to over-estimate just how elastic driver behaviors are. Although now somewhat dated, past J.P. Morgan research has shown that actual revenues of newly constructed urban toll roads have tended to disappoint predictions by 40% on average during the first three years of operation.1

1 See “Examining Toll Road Feasibility Studies” on March 22, 1996 and “Start-Up Toll Roads: Separating Winners from Losers” on May 10, 2002, both by Robert H. Muller.

Exhibit 7: CA tax-exempts are cheap versus BABsYield (%)

5

6

7

8

9

7/1/09 1/1/10 7/1/10 1/1/11 7/1/11

CA 7.55% taxable 04/01/2039 13063A5G5

Taxable Equivalent Yield

Note: Assumes a 30% marginal effective tax rate. Source: JJ Kenny, J.P. Morgan

Exhibit 5: AA tax-exempts are cheap versus BABsYield (%)

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

7/1/09 1/1/10 7/1/10 1/1/11 7/1/11

Taxable Equivalent Yield AA 30 Year Mid Yield

AA Long BAB s


Exhibit 6: A tax-exempts are cheap versus BABsYield (%)

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

7/1/09 1/1/10 7/1/10 1/1/11 7/1/11

Taxable Equivalent Yield A 30 Year Mid Yield

A Long BAB s




26

Moreover, it stands to reason that driver inelasticity is even higher now than it was in the past, for two reasons. The first reason is limited labor mobility. Skills mismatches and underwater mortgages are preventing Americans from moving as much as they used to. This makes drivers less inclined to move away from expensive toll roads. The second reason drivers are less likely to let tolls impact their behavior is that technology has fooled drivers into forgetting that they are paying tolls. Studies have shown that when a driver passes through an E-ZPass barrier he or she does not think about the cost of the toll nearly as much as when handing over cash. These factors may be mitigated by increased price sensitivity on the part of drivers during tough economic times. Importantly, the same inelasticity of demand that famously brought down a few start-up toll roads is the foremost credit strength of established toll roads. That is, those start-up toll roads failed because they were unable to divert enough drivers away from established roads. Thus, these two subsectors within surface transportation are more like substitutes than compliments. In fact, one might argue that when start-up toll roads fail to reroute drivers away from established toll roads, credit spreads in the established sector should tighten, not widen. This is not to say that both sectors are not driven by very similar credit fundamentals. Below are the five most important factors:

Low leverage: The all-important debt service coverage ratio should be calculated using net revenues in the numerator and including required deposits into the reserve fund in the denominator. Always ensure that debt service coverage is projected to stay above the median level for the bond’s rating class (Exhibit 9). This involves careful modeling of the authority’s future capital plan.

Tight flow of funds: Bondholders should have a closed-loop lien on revenues that can only be used to support the road itself.

Ample liquidity: Both debt service reserve

funds and unrestricted cash should be sufficient to get the authority through difficult periods of high gasoline prices, seismic events, or other unanticipated demand disruptions.

Strong demographics: Look for growing

populations and stable local industries, as well as high levels of income.

Independent toll-setting regime: In addition to

having a relatively low level of tolls and inelastic demand, a strong credit will have recently tested ability and willingness to raise tolls when needed. It is important to know the extent to which politicians can over-ride or roll-back toll increases.

Exhibit 9: Debt service coverage versus the median, according to Moody’s FY2010 total debt service coverage by net revenues

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

0 1 2 3 4

HCTRA(3.2x, Aa3)

BATA(1.8x, Aa3)

NYSTA(1.8x, A1)

PA Tpke.(3.0x, Aa3)

NJ Tpke.(1.4x, A3)

IL Tollways(1.7x, Aa3)

1.8x1.6x

1.3x1.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

Aa A Baa Ba

Median

Note: Moody's splits up A-rated medians into A1 (1.7x) and A2/A3 (1.5x). We consolidated these two above into A-rated for simplicity (1/3 and 2/3 weighted). Source: Moody's, S&P, J.P. Morgan

Exhibit 10: The market is priced to coverage, liquidity, and the proven ability to raise tolls Selected large toll road credits; ranked by credit spread (bp)

Basic info Indebtedness Liquidity Date of EconomySpread to Underlying Example Total amt. Actual Additional Coverage Days cash Days debt latest toll 2000-2010 Unemplymt. Per capita

Issuer AAA MMD credit rating CUSIP outs. ($mn) coverage bonds test covenant on hand reserve increase pop. growth rate incomeBATA bridges (CA) 65 Aa3/AA/AA- 072024CZ3 8,000 1.8x 1.5x 1.2x 4,872 570 7/1/2010 5.5% 10.1% 61,348Harris County (TX) 70 Aa3/AA-/AA- 414005EC8 1,155 3.2x 1.3x 1.3x 2,009 1,357 9/12/2009 20.3% 8.9% 47,394NY Thruway (NY) 115 A1/A+ 650009MF7 2,341 1.8x 1.2x 1.2x 81 186 1/1/2010 2.1% 8.0% 48,821Penn. Tpke. (PA) 125 Aa3/A+/A+ 709223YZ8 6,312 3.0x 1.3x 1.3x 102 210 1/2/2011 3.4% 8.2% 41,152IL Tollways (IL) 125 Aa3/AA-/AA- 452252CZ0 4,067 1.7x 1.3x 1.3x 295 527 1/1/2005 3.3% 9.9% 43,159Jersey Tpke. (NJ) 140 A3/A+/A 646139W92 8,200 1.4x 1.2x 1.2x 115 263 12/1/2008 4.5% 9.4% 50,781

Note: For issuers that have both senior and subordinate debt, the statistics above are for senior (except total debt outstanding which is combined). Source: Most recent issuer filing available, rating agencies, J.P. Morgan



27

With those credit factors in mind, we will highlight six of the largest toll road credits in the country (Exhibit 10):

BATA: The Bay Area Toll Authority is secured by one of the most essential urban bridge systems in the country. The authority operates seven toll bridges in the Bay Area (all the state-owned bridges except for the Golden Gate). Demand is stable, income levels are high, and the authority’s liquidity is abundant. BATA also demonstrated in early 2010 their willingness and ability to raise tolls to fund their substantial capital plan. The obvious risk when investing in tolls generated on bridges in CA is future seismic events that could shut down a bridge for some time. This risk is currently being mitigated, albeit with substantial incremental leverage, by BATA’s $9bn seismic retrofit program, featuring the $6.5bn eastern span of the Bay Bridge (Exhibit 11).

NYS Thruway: If you ever need to drive from NYC to Albany to Buffalo, you will take I-87 to I-90, passing by Syracuse and Rochester on the way (Exhibit 12). Your trip will cost only $25 in tolls (including $5 for crossing the Tappan Zee Bridge). The good news for both drivers and creditors is that $25 is a bargain for a 400 mile trip ($0.06 per mile). Before 2005, the tolls had not been increased since 1988. The bad news is that those tolls will have to keep going up to finance the Authority’s capital plan, particularly the eventual replacement and expansion of the Tappan Zee Bridge. If no such toll increases take place, coverage would fall from its current level of 1.8x to below the rate covenant of 1.2x as soon as 2013. Fortunately, the Authority has demonstrated in each of the past three years their willingness and ability to raise tolls in the face of political opposition.

Harris County Toll Road Authority: You cannot go to Houston without a car, but that is not stopping people from moving there. Last year’s Census report showed that the city’s population grew more than 20% since 2000. Bucking the trend in the US, traffic levels are actually higher in Houston than they were before the recession. The city is encircled by highways, many of which are operated by HCTRA (Exhibit 13). But the roads are not

Exhibit 12: New York operates the largest thruway system in the country The NYC Thruway system includes 570 miles of roadway

Source: NYSTA

Exhibit 11: Building bridges, mitigating risksBATA is building the world’s largest self-anchored suspension bridge (left below) to replace the eastern span of the San Francisco Bay Bridge (right below)

Source: BATA

Exhibit 13: Houston is encircled by highways HCTRA operates the Sam Houston Tollway (ring around the city), the Hardy Toll Road (northbound spoke), the Westpark Tlwy., Spur 90A, and the Katy Mng. Lanes

Source: Google Maps



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cheap to drive on, costing $0.15-$0.20 per mile in tolls. The ABT is 1.25x net revenues (or 1.25x gross), but the 1.25x rate covenant is weaker because it is on gross revenues. The credit is strengthened by being backstopped by a tax pledge from AAA-rated Harris County.

Pennsylvania Turnpike: With robust senior lien

coverage and ample liquidity, this road has a long history of well-managed finances, going back over 70 years. Originally financed by a loan from the New Deal in 1940, the PA Turnpike was the first modern intercity toll road. It was not until after the Second World War when traffic levels surged that other states such as NY and NJ built similar intercity toll roads, financed with revenue bonds. The PA Turnpike Commission (PTC) has broad powers to scale back capital and borrowing plans, as well as to increase tolls (as demonstrated with toll increases in 2009 and 2010). There is a meaningful difference between the senior and subordinate liens in this credit, in part because of the subordinated payments due to PennDOT. In 2007, the PTC agreed to pay PennDOT as much as about $900mn annually to operate and toll I-80. But now those payments will be cut in half because last year the US DOT denied PTC the right to toll the interstate. PennDOT thinks the payments should decline in FY2012, whereas PTC thinks they should decline in FY2011. Nevertheless, PTC included in the budget the full $922mn payment in FY2011, more than half of which is funded by the issuance of third lien bonds.

New Jersey Turnpike: Operating both the NJ

Turnpike and the Garden State Parkway, this credit has a broad and well-established revenue base with inelastic demand, low toll rates and limited competition in a high-income state. These factors suggest significant economic capacity to raise tolls further to lift coverage. Unfortunately, rate-setting is not fully independent from state politics and toll revenues can be siphoned off to pay for non-turnpike purposes. After the ARC tunnel to Manhattan was canceled last year, the legislature tried to roll back the portion of the 2008 NJTA toll increase that was slated to support the tunnel. Instead, the

moneys may be redirected to support the state’s transportation trust fund.

Illinois Tollways: Highly essential system in northeastern IL with strong liquidity. Management is not contemplating revenue enhancements, despite coverage falling below their target of 2x. This number could fall even lower if traffic volumes disappoint, or new debt is issued to fund the second phase of the state’s congestion-relief capital program (on top of the current escalating debt service schedule). Moody’s also notes that in the 47-year history of the authority, there were only two toll increases prior to the January 2005 adjustment, and one of those was subsequently rolled back.



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Supply forecast Monthly tax-exempt bond issuance ($ bn) Monthly tax-exempt net supply/(redemptions) ($ bn)

0

10

20

30

40

50

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

5-year average (2006-2010) 2011

2011 actual 2011 forecast

2011 total = $258

-20

-10

0

10

20

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

5-year average (2006-2010) 2011

2011 actual 2011 forecast

Source: Bond Buyer, J.P. Morgan Source: Bond Buyer, IDC, J.P. Morgan

Interest rate forecast Yield (%)

9/23/11 9/30/11 12/31/11 3/31/12 6/30/123Q11 4Q11 1Q12 2Q12

Treasury Current Forecast Forecast Forecast Forecast2yr 0.21 0.25 0.35 0.40 0.405yr 0.37 0.95 1.30 1.45 1.6010yr 1.83 2.05 2.60 2.80 3.0030yr 2.90 3.35 3.90 4.10 4.25

AAA tax-exempt2yr 0.32 0.36 0.40 0.43 0.435yr 0.90 0.91 1.15 1.22 1.3810yr 1.97 2.12 2.50 2.81 2.7930yr 3.44 3.72 3.93 4.13 4.32

Source: J.P. Morgan


David MackieAC Nicola Mai Malcom Barr Joseph Lupton Greg Fuzesi Gianluca Salford J.P. Morgan Securities Ltd.

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Special Topic: Directing the Greek tragedy: default, a regional recession, and spillover risks

The implicit contract between Greece and the rest of the euro area—official support in exchange for a good faith effort—is breaking down. Greece is failing to deliver on structural reforms amid continuing slippage in fiscal outturns, while attitudes among official creditors are hardening. The pretence of a return to fiscal sustainability sponsored by cheap official loans—without a big write-down of private sector debt—cannot be maintained. Without appropriate effort from Greece—on both the deficit and asset sales—the current strategy is putting too much of Greece’s overall liabilities too quickly into official hands

A second, much harder debt restructuring now seems inevitable, following the PSI agreed in July. Official creditors will seek to manage the process as debt in private sector hands is substantially marked down. This will produce worse macroeconomic outcomes for both Greece and the rest of the region

The Greek recession will get much deeper. After the 12% decline in GDP seen thus far, the shock from a harder debt restructuring will generate a further fall in activity, taking the total peak-to-trough decline in Greek GDP to around 20% by the end of 2012. Pressure on other sovereigns to close their fiscal deficits will remain intense—Italy looks to have slipped back into recession already, which will deepen next year as fiscal austerity bites

A mild recession in the euro area is now likely, starting in 4Q. A deep recession will only be avoided if the mechanisms to limit contagion are dramatically upsized and actively used. The EFSF’s capacity for bank recapitalizations and sovereign support will need to be significantly upsized. Joint and several guarantees on EFSF debt, or turning the EFSF into a bank, will be needed for this up scaling to occur

The ECB will need to be very active. The ECB’s hope that EFSF ratification will enable it to cease engaging in bond market support will be dashed. The total of its Securities Market Program bond purchases, and eventually loans to the EFSF, could reach €1,000bn. On the conventional policy side, the ECB will reduce the main policy rate to 1% in October, but with unlimited liquidity support to banks, the actual overnight rate will be a lot lower

Greece’s path ahead does not look bright, even with much of its debt burden removed. With broad-based structural problems and no support from a weaker currency, Greece will not return to growth for a long time. In our view, exiting the monetary union would make the situation much worse in the near term, while the medium-term benefits of exiting would be very uncertain

Managing a Greek default will force the region to confront its political future. Many believe that further fiscal integration is needed to ensure the survival of the euro area. It is not exactly clear what is needed, but there is recognition among policymakers that the governance agreement in March falls short. Reaching a consensus on what further fiscal integration will entail will be difficult and any significant steps from here would likely require a new area-wide treaty and constitutional change at the national level. If the region chooses to have this debate, the process of preparing the support mechanisms for a second, harder Greek debt restructuring will provide a bridge to enable a longer-term debate to take place

Introduction and overview

Although the original architects of EMU anticipated that default and debt restructuring would be the ultimate sanction on a sovereign that failed to manage its fiscal affairs appropriately, policymakers in the region have been reluctant to accept this outcome in the current crisis. Indeed, for a long time policymakers failed to acknowledge that Greece was insolvent and thus needed a significant amount of debt relief. This position changed in July with the decision to involve the private sector in the second Greek bailout package. However, the amount



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of debt relief embedded in the debt restructuring agreed in July was very modest.

The position of policymakers may be about to shift again. The attitude of the creditor countries seems to have hardened over recent weeks. This is clear in the demand for further action from Greece before it receives the sixth tranche of the first bailout package, and in the broader discussion about whether default is acceptable and whether an EMU expulsion mechanism needs to be created. Our inclination is to think that the Greek government will respond sufficiently to ensure ongoing financing in the near term. But, even if default is avoided in the coming weeks, the issue is not dissipating. The July PSI continued to treat the Greek situation as largely a problem of liquidity rather than one of solvency, a perspective that very few share.

As time passes, it is becoming increasingly clear that Greece will need a much more extensive debt restructuring than agreed in July, in order to limit the shift of liabilities to the official sector. Weak nominal activity and ongoing slippage relative to program objectives suggest that the debt level will remain high even after the private sector involvement (PSI) agreed in July is completed. And, fiscal underperformance is unlikely to change by enough to satisfy the official lenders. While some underperformance can be put down to the deeper-than-expected recession, it also reflects the weakness of institutional structures (e.g., tax collection), a reluctance to tackle vested interests aggressively, and the social unrest that is weighing on both activity and revenue collection.

This suggests that the region will face some difficult decisions in the months ahead. The implicit contract between the rest of the region and Greece—official financial support in exchange for a good faith effort—is breaking down. Policymakers have three options to choose from: first, the current approach of muddling through could continue to the end of the second bailout program; second, external support could be shut off and Greece could be left to default in a disruptive way; or third, a managed, harder debt restructuring could occur with some additional support for Greece to cushion the impact and an aggressive use of crisis mechanisms to shore up the rest of the region.

We do not believe that the first possibility is viable, while the second possibility would expose both Greece and the rest of the region to a huge financial and economic shock. This suggests to us that a managed, harder restructuring will occur. This will mean that the recession in Greece becomes deeper and drags longer, resulting in a huge cumulative decline in the level of GDP. The impact on the rest of the region will largely come through contagion to the rest of the periphery in the form of weaker asset prices, higher government bond yields, lower sentiment, and increased stress in the banking sector. This in turn would impact the core via trade, sentiment, asset prices, and the financial system. A second, harder debt restructuring, which this analysis assumes will take place in the early part of next year, is

Exhibit 1: Official perspectives on the Greek outlook2010 2011 2012 2013 2014

Real GDP (%oya) -4.0 -2.6 1.1 2.1 2.1GDP deflator (%oya) 1.2 -0.5 1.0 0.7 1.0Deficit (% of GDP) -8.1 -7.6 -6.5 -4.9 -2.6Primary (% of GDP) -2.4 -0.9 1.0 3.1 5.9Debt (% of GDP) 133.2 145.2 148.7 149.2 146.1IMF fourth review (July 2011)Real GDP (%oya) -4.5 -3.9 0.6 2.1 2.3

GDP deflator (%oya) 2.3 1.7 0.7 1.0 1.0

Deficit (% of GDP) -10.4 -7.6 -6.5 -4.8 -2.6

Primary (% of GDP) -4.9 -0.8 1.5 3.6 6.4

Debt (% of GDP) 142.7 165.9 172.1 169.7 159.8

Original program (May 2010)

Exhibit 2: J.P. Morgan Greek outlook

2010 2011 2012 2013 2014Muddle through scenarioReal GDP (%oya) -4.5 -6.2 -2.8 -1.4 -0.7

GDP deflator (%oya) 2.3 1.7 0.5 0.5 0.0

Deficit (% of GDP) -10.4 -9.1 -8.2 -6.9 -4.6

Primary (% of GDP) -4.9 -2.3 0.6 2.0 4.8

Gross debt (% of GDP) 142.7 157.8 181.3 188.8 190.4

Adj. debt (% of GDP) 142.7 157.8 165.1 172.4 173.9

A second, harder debt restructuringReal GDP (%oya) -4.5 -6.3 -5.9 -3.3 -0.3

GDP deflator (%oya) 2.3 1.7 -1.0 -1.5 -1.5

Primary (% of GDP) -4.9 -2.3 0.8 0.9 0.8The muddle through scenario inlcudes the July PSI but not a second, harder debt restructuring. Adjusted debt takes account of the defeasance of the principal of the new bonds after the exchange. The second, harder debt restructuring scenario incorporates the July PSI and another debt restructuring in the spring of 2012. We have not included deficit and debt projections due to the huge uncertainty about how coupons and principal will be reduced in a second debt restructuring.



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now incorporated into our central projection for euro area economic growth. It will have a huge impact on the Greek economy, even with some ongoing financial support, and will help to push the region as a whole back into recession. This recession will only be mild if policymakers prepare the support mechanisms (the EFSF and the ECB) and use them aggressively.

This note explains why the muddle-through scenario does not really look sustainable, what the macro consequences of a second, harder debt restructuring might be, how the area-wide support mechanisms (the EFSF and the ECB) can help to cushion the impact, and why a second, harder debt restructuring does not mean that Greece will leave the monetary union. The note ends with some thoughts about the outlook beyond the second Greek debt restructuring.

A second, harder debt restructuring and a broader and more active set of supports from the EFSF and the ECB, should help to move Greece to a more sustainable debt position, but will not fully resolve the euro area crisis. Alongside these developments, we expect politicians to engage in a fundamental debate about where the region should be heading in the medium term. This process will take some time, but the EFSF and the ECB, if expanded and strengthened in the way that we expect, will provide a bridge to give the region time to reach an agreement on what deeper fiscal and political integration should look like.

A muddle through scenario

It is possible to lay out a muddle through scenario which assumes that Greece delivers whatever is necessary to ensure the disbursement of the sixth tranche of the original bailout package in October, that the private sector involvement agreed in July is successful and delivers a significant amount of financing in the second bailout package, and that Greece does enough to ensure future disbursements even if it continues to undershoot the program objectives.

We have already made an attempt to evaluate Greece’s financing needs in this muddle through scenario. That analysis assumed that Greece would receive additional support for bank recapitalization that the PSI would take place as envisaged in July, and that Greece would borrow from the EFSF to buy debt in the secondary market.

However, while that analysis took account of all of the aspects of the second Greek package, it was based on the official projections for growth and the fiscal deficit. It is now apparent that Greek GDP growth will be significantly weaker this year—we now expect a contraction of 6.3% rather than the 3.9% in the official projections—and that the deficit will be significantly wider—we now anticipate an overall deficit of 9.1% of GDP rather than the 7.6% in the official projections. Moreover, growth in the future is also likely to be significantly weaker than the official projections.

We have now amended the Greek growth outlook in this muddle-through scenario to take account of three things: first, additional pressure on Greece to put the deficit back on track; second, a more subdued regional and global backdrop over the coming 18 months; and third, more persistent drags from restrictive credit conditions, social unrest, and weakness in sectors such as tourism. Over the coming three years, real GDP will likely contract in the muddle-through scenario by an average of 1.6%, compared with the average growth rate of 1.7% in the official projections. Weaker real growth is also likely to push inflation down, generating an even softer profile for nominal GDP. Meanwhile, despite ongoing pressure, we

Exhibit 3: Greek financing muddle through scenario€ bn 2011 2012 2013 2014Gross borrowing needs 61.5 126.6 36.3 32.1Fiscal balance 20.0 17.6 14.6 9.8Amortization market short term 9.2 6.2 6.2 6.2Amortization market medium term 28.1 17.1 10.8 15.2Amortization official loans 0.0 0.0 0.0 0.0Other borrowing needs 4.2 85.7 4.7 0.9Gross financing sources 61.5 126.6 36.3 32.1Privatization receipts 4.0 7.0 7.0 10.0Other financing sources 4.5 0.0 0.0 0.0Market access short term 6.2 6.2 6.2 6.2Market access medium term 0.0 0.0 0.0 0.0Official loans 46.8 113.4 23.1 15.9

Total 347.1 389.9 402.2 402.9Market debt 268.8 198.2 187.4 172.2Official loans 78.3 191.7 214.8 230.7Nominal GDP 220 215 213 211.6Deficit (% of GDP) -9.1 -8.2 -6.9 -4.6Gross debt (% of GDP) 157.8 181.3 188.8 190.4

Adj. debt (% of GDP) 157.8 165.1 172.4 173.9

Stock of outstanding liabilities

Adjusted debt takes account of the defeasance of the principal of the new bonds after the exchange.



33

expect Greece to continue to fall short of the budgetary objectives in the program, which means that the borrowing requirement will be higher in the coming years. And, slippage in the privatization program would put further upward pressure on Greece’s gross borrowing need.

A persistently wider deficit, the greater cost of the AAA collateral for the debt exchange and an undershoot on asset sales mean that Greece will need even more official support in the coming years than the €109bn assumed in the second bailout program, given the political and social limits on ever-increasing amounts of austerity. Moreover, the debt-to-GDP ratio is likely to remain elevated during the term of the second bailout package, despite the PSI that has been agreed. In our forecast, immediately after the July announcement, we anticipated a gross debt-to-GDP ratio of 163% in 2014. Our new projections for the muddle-through scenario put the gross debt-to-GDP ratio in 2014 at 190%. Given the defeasance of the principal of the new bonds by the AAA zero coupon instruments, it is probably more appropriate to look at a measure of debt that excludes the cost of purchasing the collateral. On this basis, the Greek debt-to-GDP ratio in 2014 will be around 174%, higher than it is now. With ongoing wide deficits and extremely weak nominal GDP, Greece will not be able to stabilize its debt-to-GDP ratio over the horizon of the second bailout package.

Given these deficit and debt dynamics, it is clear that the muddle-through scenario is not sustainable. It seems inevitable that Greece will need a much more extensive debt restructuring than what was agreed in July. This would reduce overall deficit by dramatically reducing coupon payments and would reduce the objective for the primary surplus, as less principal would need to be repaid. If the July PSI goes through, with 75% participation, and debt buybacks occur in line with the July agreement, then there will be around €185bn of Greek market debt in private hands (excluding the Eurosystem). But, €113bn of this will be the new bonds after the exchange, which would have their principal protected. Of the remaining €72bn, €48bn represents bonds maturing between now and 2020, which did not take part in the debt exchange, and €24bn represents bonds maturing after 2020. Given the defeasance of the principal of the new bonds, the second, harder debt exchange will need to focus on coupon payments as much as principal.

Many refer to a second debt restructuring as default, and the image is that Greece is left to fend for itself as the official creditors withhold financing in frustration at Greece’s underperformance. In our view, this is unlikely to happen. It is more likely that Greece, the rest of the euro area, and the IMF reach an agreement together that a more extensive debt restructuring is needed and that they try to manage the process in a way that minimizes disruption. Even if this is what happens, a key uncertainty is timing. It would make sense to do the more extensive debt restructuring now, before the PSI that was agreed in July goes through. If that PSI is finalized, the options for a second, harder debt restructuring are more limited due to the defeasance of the principal of the new bonds. However, it seems unlikely that the PSI agreed in July will be abandoned, unless the sixth disbursement from the original bailout package is withheld in early October. The analysis in this note assumes that the PSI agreed in July will go through and that a second, harder debt restructuring will occur in spring of next year.

Exhibit 4: Argentinean growth around the 2001 default

% changesFrom 4Q00 to trough after

defaultFrom 3Q01 to trough after

defaultGDP -15.1 -10.3Private consumption -19.6 -14.1Public consumption -8.9 -6.6Capital spending -46.7 -36.4Exports -0.2 n.aImports -60.2 -51.3This table shows the declines in activity around the time of the Argentinean default in 2001, from before the default to the trough in the level of activity after the default. Exports hit a trough in the final quarter of 2001 and grew thereafter. Exhibit 5: Argentina and Greece % of GDP

t-1 t-2 t (default) t+1 t+2

Deficit -2.5 -2.4 -3.6 -1.2 0.5Primary 0.4 1.0 0.2 0.9 2.3Debt 43.0 45.0 53.7 149.9 138.0Current account -4.2 -3.2 -1.4 8.4 5.7

Deficit -15.5 -10.4 -9.0Primary -10.3 -4.9 -2.2Debt 127.0 143.0 159.4Current account -11.0 -10.4 -8.2The Argentinean default occurred in December 2001, so in this table t=2001. For Greece t=2011. Source for the Argentinean data, Sturzenegger and Zettelmeyer, Debt Defaults and Lessons from a Decade of Crisis, 2006.

Argentina

Greece



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The macro consequences of a second, harder debt restructuring

Gauging the macro consequences of a second, harder debt restructuring in Greece is difficult due to a number of important uncertainties: the magnitude of the restructuring that is imposed; the extent to which private creditors have already adjusted by marking their balance sheets to market prices; the extent to which Greece gets further financial support to provide ongoing financing for the deficit and to recapitalize banks; and the extent to which the support mechanisms for the region as a

whole—the EFSF and the ECB—are aggressively utilized.

The channels through which a second, harder debt restructuring would impact the Greek economy are fairly clear. Domestic demand would fall further as the credit crunch intensified (banks would become much more stressed and severe capital controls on the deposit base would need to be imposed), asset prices and confidence would slide a lot more, social unrest would increase further, exports would be disrupted due to reduced trade finance, and outward migration would likely rise sharply. The impact on domestic output would be mitigated by a

The options for a second, harder debt restructuring

If the debt exchange agreed in July goes through, then Greece’s options for a second, harder debt exchange are constrained by the defeasance of the principal of the new bonds. This means that Greece is unable to default on the principal of any new bond created by the exchange. Accordingly, a second, harder debt restructuring will have to involve some combination of: the coupon and principal of the bonds that were eligible for the first exchange but did not participate, the coupon and principal of bonds maturing beyond 2020 that were not eligible for the first exchange, and the coupons of the new bonds created by the exchange.

In the first exchange, the improvement in cash flows is entirely due to lower redemptions, whereas interest payments would actually increase modestly because Greece has to pay the coupon on the new bonds and the interest on the loan from the EFSF to finance the purchase of the AAA assets. In contrast, a second, harder debt restructuring would need to involve a much more extensive reduction in coupon payments.

In order to gauge what kind of second, harder debt restructuring could take place, we split Greece’s borrowing needs immediately after the PSI between old bonds, new bonds, and other sources (to simplify these calculations, we are ignoring the evolution of the budget position, asset sales, and the need for bank recapitalization). Over the next 10 years, more than €120bn will be paid to holders of old bonds covering both coupons and redemptions. Thus, significant savings could

be achieved by restructuring these bonds, which would be reasonably straightforward given that they are regulated by domestic legislation.

One problem however is that roughly half of the old bonds are held by the Eurosystem.

Our calculations suggest that around €40bn of coupon payments for the new bonds will be due between now and 2020. It would be slightly more difficult to execute a debt restructuring for the new bonds as they will be written under English law—we expect them to require a super majority of investors to accept the new terms.

Putting all this together, if we assume that the Eurosystem’s holdings and other liabilities are not impacted, the maximum amount that could be extracted from private investors in bonds maturing up to 2020 would be €100bn, split roughly in half between coupons and principal.

Exhibit 6: Greek cash flows after July PSI € bn

50% old +Old bonds Other Old bonds New bonds Other new bonds

2011 6 0 1 0 0 42012 14 6 5 4 5 142013 14 6 4 4 5 142014 16 6 4 4 5 142015 9 6 3 4 5 102016 7 9 3 4 4 92017 10 4 2 5 4 112018 4 4 2 5 4 82019 11 4 2 5 4 112020 2 4 1 5 3 7

Total 94 47 27 41 39 102

Redemptions Interest

This table shows the split of redemptions and interest payments after the PSI. We assume that Eurosystem holdings would not be subject to a second, harder debt restructuring.



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significant compression of imports, partly related to the fall in domestic demand itself and partly due to more limited credit availability, but the impact of a harder debt restructuring on domestic output would still likely be significant. With activity contracting significantly in an underlying sense, a substantial fiscal tightening would be needed to narrow the fiscal deficit to whatever level could be funded by the ongoing official support. This tightening would put more downward pressure on domestic demand and output. Eventually, the situation would stabilize, but at a much lower level of activity.

It is very hard to gauge what the fall in Greek GDP would be in the event of a harder debt restructuring. One end of the range of possibilities is suggested by looking at Argentina, whose default in December 2001 is the largest sovereign default to date. The sovereign stress in Argentina built significantly during 2001—there were two debt restructurings during that year before the default occurred at the end of December. The adjacent table shows the evolution of Argentinean GDP, consumption, capital spending, and imports from the end of 2000 to the trough after the default, and from the third quarter of 2001 to the trough after the default. GDP and domestic demand fell significantly, although some part of the weakness occurred in the run-up to the actual default rather than after it.

If Greece were to follow in Argentina’s footsteps—essentially a default with no ongoing external support—the impact on Greek GDP would likely be larger than what was seen in Argentina, for a number of reasons. First, the Greek fiscal situation in the run-up to default is worse and the amount of outstanding sovereign debt is much larger. Second, given Greece’s membership in the euro area and the EU, the prospect of capital flight and outward migration is much greater. Third, the political and social stress in Greece is already severe and further pressure raises the prospect of institutional breakdown. And fourth, Greece would not enjoy any cushioning effects of significant currency devaluation if it stays in EMU.

The Argentinean experience suggests to us that a disruptive Greek default with no ongoing financial support could push GDP down by a further 20%. This would represent a huge additional decline in GDP on top of the 12% fall that Greece has already experienced. In fact, Greece is unlikely to follow exactly in Argentina’s

footsteps: the magnitude of the ultimate hit to the NPV of the debt might be similar, but in our view Greece is likely to receive more external support to cushion the impact of the debt restructuring. The rest of the Euro area will almost certainly provide further financial support to limit the damage to the equity of the banking system, and the ECB, both directly and via the ELA, will continue to meet the liquidity needs of the Greek banking system. The official sector may also lend to Greece to ensure that it remains current on its interest payments on the outstanding official loans. This suggests that the impact of a harder debt restructuring on GDP would be significantly less than 20%. Our new forecast has a total cumulative decline in the level of GDP, from the peak seen in 2008, of around 20%.

The impact on the rest of the region

One channel through which a harder debt restructuring in Greece will impact the rest of the region is through trade flows, but this is only of very limited importance. Exports to Greece account for less than 0.5% of GDP for all of the euro area member countries except Cyprus and Malta. However, there are a number of important financial linkages that will matter a lot more.

At first glance, the aggregate exposure to Greece for the euro area banking system as a whole appears manageable. According to BIS data, the aggregate exposure of French banks to Greek debt (total of sovereign, bank, and private sector liabilities) is close to €40bn. Comparing to a bank capital of almost €500bn, even a 75% write-down of all of that exposure would deplete French bank capital by just 6%. For German banks, a 75% write-down of all Greek exposure would erode the capital base by just over 3%. For other national banking systems in the region, the direct exposure to Greece is even smaller relative to bank capital. However, the key issue for the Euro area banking system is not the magnitude of the losses on loans to Greece per se; rather it is the extent to which a harder Greek debt restructuring prompts intensifying weakness in asset prices across the periphery as a whole, particularly in Italy and Spain. To the extent that happens, significant further stress would be put on banks in the core countries.



36

A harder debt restructuring for Greece is likely to be seen by some as a template for measures that may ultimately be taken in other countries where debt burdens are high. It may also be seen as indicative of weakening support for the fiscally challenged from Germany and other AAA countries. As these concerns, and the losses being realized on loans to Greece, push asset prices lower across the periphery, the threat to bank capital positions in the region becomes more troubling. Exposures of French banks to the sovereign and bank debt in Italy and Spain amount to 38% of bank capital. For Germany, the figure is 49%. If exposures to the non-financial private sector are also included, the numbers get very large. Mutually reinforcing concerns about sovereign solvency and the adequacy of euro area bank capital have been emblematic of the crisis to date. A second, harder Greek debt restructuring would likely cause that process to intensify.

Thus, the key issue for the rest of the region is contagion, which means that the actual impact on the region’s economies will be determined by how well policymakers have prepared for the event. In our view, this preparation will involve an enlarged and more active EFSF and a central bank willing to provide not only significant amounts of liquidity support to banks, but also a significant amount of liquidity support to sovereigns, either directly or via the EFSF.

Our growth forecast for the region is being changed for three reasons. First, we are downgrading our assessment of the underlying situation around the periphery as fiscal austerity bites hard. Second, we are incorporating the impact of a prolonged period of heightened stress in the banking sector, which will lead to tighter credit conditions over time. And third, we are incorporating the impact of a second, harder debt restructuring in Greece. It is difficult to fully disentangle all the forces at work at the moment: heightened stress in the region—evident in sentiment, asset prices, and bank funding—reflects not only the anticipation of a Greek default, but also broader concerns about the global economy and the political situation in Italy. The region is now assumed to slide into a mild recession starting in the final quarter of this year. But, it is important to stress that this outcome depends on aggressive actions by euro area policymakers, both in Greece itself and in the euro area as a whole. This action involves ensuring that there are mechanisms to provide huge amounts of liquidity to sovereigns and banks (the

EFSF and the ECB) and ensuring that banks are appropriately recapitalized across the region. In the absence of an aggressive policy response, the region would likely fall into a deep recession. Given that there is scope for policy to fall short of what is needed, downside growth risks still exist.

Exhibit 7: Consolidated foreign claims of the banking sector € bn, ultimate risk basis (as of March 2011)

All France Germany UK USGreece 98 40 17 10 6Sovereign 32 9 10 3 1Private sector 66 31 7 8 5GRC, IRL, PRT 581 81 126 125 52Sovereign 69 18 18 7 3Banks 510 12 30 16 14…plus ITA and ESP 1,735 473 368 245 123Sovereign 345 115 75 22 18Banks 1,388 359 293 223 106Memo: Bank capital (€ bn) n.a 493 391 761 1,006

Source: Bank of International Settlements, ECB, FDIC

Note: "all" refers to all 24 reporting countries. Total excludes derivatives and other commitments.

Exhibit 8: Forecast changes Real GDP, %oya

2011 2012 2011 2012Euro area 1.6 0.9 1.6 -0.5Germany 2.8 1.3 2.8 0.2France 1.6 1.3 1.6 -0.1Italy 0.6 0.6 0.5 -1.2Spain 0.7 0.4 0.7 -0.6Greece -3.9 0.6 -6.3 -5.9Ireland 0.4 1.1 2.1 0.3Portugal -1.4 -1.9 -1.6 -2.8

Old forecast New forecast

The new Irish forecast for 2011 is higher than the old one due to the strong GDP performance in 2Q and an upward revision to 1Q (released this week). Exhibit 9: New quarterly GDP projections % q/q, saar

3Q11 4Q11 1Q12 2Q12 3Q12 4Q12Euro area 0.5 -0.5 -1.0 -1.5 0.0 1.0Germany 1.5 -0.5 0.0 -0.5 0.5 1.0France 1.0 0.0 -0.5 -1.0 0.5 1.0Italy -1.0 -1.5 -1.5 -2.5 -0.5 0.5Spain 0.0 -1.0 -1.0 -1.5 0.0 1.0Greece -5.0 -3.0 -6.0 -10.0 -8.0 -3.0Ireland 1.0 0.0 -0.5 -1.0 0.5 1.0Portugal -5.0 -3.0 -3.0 -3.5 -1.5 0.0



37

An enlarged and more active EFSF

The EFSF will play a significant role in helping to contain the macro consequences of a second, harder debt restructuring in Greece, although it will need to be larger and more active than it has been until now.

The EFSF was originally scaled to meet—along with support from the IMF and the EFSM—the gross financing needs of Spain, Ireland, and Portugal over a 3-year horizon (Greece had its own bilateral program at the time the EFSF was set up). In the future, the EFSF’s resources will be used not only for sovereign bailouts, but also for interventions in the primary and secondary debt markets and for bank recapitalization in countries that are not in a formal bailout program. Given this wide range of tasks, its lending capacity will need to be increased significantly.

Assuming that the current parliamentary ratification process is successful, the EFSF’s effective lending capacity will increase to €440bn, of which €280bn will be available to use given the commitments that have already been made to Greece, Ireland, and Portugal. Added to this, there is around €10bn of spare capacity from the EFSM (of the original €60bn) and an ill-defined amount available from the IMF. If it is assumed that the total contribution from the IMF is close to the original expectations of €250bn, then the region currently has the ability to draw on around €450bn. Some of these funds will likely be needed for extensions of the Portuguese and Irish bailout packages, which assume that these sovereigns can re-access capital markets in 2013—some will be needed for bank recapitalizations and some will be needed for primary and secondary bond market interventions. Given the need to create a buffer to potentially support Spain and Italy if they lose market access, the capacity of the EFSF will likely need to be tripled or even quadrupled.

Given the current starting point, we can think of at least four ways in which the lending capacity of the EFSF can be increased: first, an expansion of the pro rata guarantees; second, issuance of AA rated bonds; third, a move to joint and several guarantees; or fourth, turning the EFSF into a bank (see box below).

Most likely, the only way that the EFSF could provide widespread support to sovereigns in size and on a timely

basis would be if it were turned into a bank and in our view this is becoming the most likely avenue for further EFSF expansion. In addition to its direct and indirect support for sovereigns, the EFSF is likely to be involved in forced recapitalizations of euro area banks, possibly mimicking the behavior of the US TARP.

Exhibit 10: EFSF guarantee structure (pro rata guarantees)€ bn, unless otherwise stated

Credit rating (S&P/Moodys/

Fitch)

Original EFSF maximum guarantee

Commitments

Amended EFSF

maximum guarantee

Commitments

Adjusted EFSF contribution

key (%)

Austria (AAA/Aaa/AAA) 12.2 21.6 3.0Belgium (AA+/Aa1/AA+) 15.3 27.0 3.7Cyprus (BBB+/Baa1/BBB) 0.9 1.5 0.2Estonia (AA-/A1/A+) 0.0 2.0 0.3Finland (AAA/Aaa/AAA) 7.9 14.0 1.9France (AAA/Aaa/AAA) 89.7 158.5 21.8Germany (AAA/Aaa/AAA 119.4 211.0 29.1Greece (CC/Ca/CCC) 12.4 21.9 0.0Ireland (BBB+/Ba1/BBB+) 7.0 12.4 0.0Italy (A/Aa2/AA-) 78.8 139.3 19.2Luxemb. (AAA/Aaa/AAA) 1.1 1.9 0.3Malta (A/A2/A+) 0.4 0.7 0.1Netherl. (AAA/Aaa/AAA) 25.1 44.4 6.1Portugal (BBB-/Ba2/BBB-) 11.0 19.5 0.0Slovakia (A+/A1/A+) 4.4 7.7 1.1Slovenia (AA/Aa2/AA) 2.1 3.7 0.5Spain (AA/Aa2/AA+) 52.4 92.5 12.8Total 440.0 779.8 100.0Of which: AAA 255.4 451.5 62.2



38

Expansion through joint and several guarantees. Many see joint and several guarantees on debt issuance by the EFSF as the most attractive way of significantly expanding its capacity. But, this move looks dangerous in the absence of a much improved fiscal governance structure in the region. Suppose, for example, that the EFSF’s lending capacity of €440bn is achieved through joint and several guarantees rather than pro rata guarantees. All of a sudden, the contingent liability of existing sovereigns would be inflated significantly, as every country would be responsible for the whole of the guaranteed amount. If the EFSF were doubled or tripled, the consequences would be even more dramatic. Let’s take Germany again as an example. With a €440bn joint and several guaranteed EFSF, Germany’s debt-to-GDP ratio including EFSF contingent liabilities would amount to 101%, and to 118% and 136% with a doubled and tripled EFSF, respectively. Under a tripled EFSF, Finland would be guaranteeing an absurd 780% of GDP. Given the extreme move in contingent liabilities that joint and several guarantees would imply, it is not clear whether the EFSF could be expanded in this manner without some additional control over national fiscal policy, essentially a step toward a common Eurobond.

Turning the EFSF into a bank. Another way of expanding the EFSF’s capacity is to turn it into a bank, as suggested by Daniel Gros and Thomas Mayer in a recent report published by the Centre for European Policy Studies. The idea is that, alongside its current functions, the EFSF could fund secondary market bond operations by accessing ECB facilities using the bonds as collateral. In essence this is not really any different from the ECB purchasing the debt directly: the EFSF would have assets that were peripheral debt and liabilities that were central bank loans. But, if significant debt monetization is necessary to support the region, it is important to ask which institution is best placed to conduct the operations. By delegating the task to the EFSF, it makes the location of the associated credit risk clearer (with the fiscal authorities), and it could be argued that the EFSF has more legitimate authority to add a layer of conditionality to its actions. In this regard, it is worth noting that money-financed asset purchases in the UK are conducted by a state capitalized entity (the Asset Purchase Facility).

Options for expanding the EFSF

Expansion of pro rata guarantees. One way to expand the EFSF is to increase the pro rata guarantees provided by sovereigns, or at least those provided by the AAA countries. Current pro rata guarantees represent a contingent liability for the sovereigns worth around 8.5% of GDP in each country (although, to the extent that this does not include a guarantee on interest payments, the contingent liability could actually be higher). Doubling or tripling that amount means that this contingent liability would climb to 17% of GDP and 25% of GDP, respectively. Take the case of Germany, for example. The German gross debt-to-GDP ratio last year was around 83%. Given the current EFSF commitment, the “debt-to-GDP ratio including EFSF contingent liabilities” is around 92%. If the EFSF is doubled, that ratio moves up to 100%, and if tripled, to 109%. A similar pattern would be followed in France, where the debt-to-GDP ratio in 2010 was close to 82% and is augmented in a similar way by EFSF guarantees. This simple calculation shows that enlarging the EFSF meaningfully has a significant impact on the exposure of sovereigns in the region. It is not clear for example that a country like France, which was running a primary deficit of 4.5% of GDP last year, can take on that much in the way of contingent liabilities without its credit rating being affected or its funding costs rising meaningfully.

Expansion by allowing EFSF bonds to be rated AA. An option to increase the EFSF’s lending capacity while maintaining the current pro rata guarantee structure is to allow EFSF bonds to be rated AA. Given that the sovereigns that could be added as guarantors under this scenario are Belgium, Spain, and possibly Italy, there is not much to be gained in terms of an expanded guarantor base (Spain and Italy are part of the reason why the EFSF needs to be extended). Such a lower rating could be useful to the extent that the AAA country guarantees could count more than 1-for-1 toward the fund’s lending capacity, but it is not clear that the rating agencies would treat the structure in this way. The lower rating would, however, make the fund more resilient if one of the AAA sovereigns were downgraded. But, it is not clear that there would be an appetite for AA-rated EFSF bonds and the yield at which the EFSF funded itself could end up being too high.



39

Exhibit 13: Government gross debt including contingent EFSF liabilities% GDP

Debt 2010 (ex. contingent liabilities)

With original EFSF

With amended EFSF

With a doubled pro rata EFSF

With a tripled pro rata EFSF

With joint and several

guaranteed €440bn EFSF


guaranteed doubled EFSF


guaranteed tripled EFSF

Austria 72.3 76.6 79.9 87.5 95.1 227.2 382.1 537.0Belgium 96.8 101.1 104.5 112.1 119.8 221.5 346.1 470.8Cyprus 60.8 65.7 69.5 78.3 87.0 2580.1 5099.4 7618.7Estonia 6.6 6.6 20.3 34.1 47.8 3040.8 6075.1 9109.4Finland 48.4 52.8 56.1 63.9 71.6 292.4 536.5 780.5France 81.7 86.3 89.8 98.0 106.1 104.3 126.9 149.5Germany 83.2 88.0 91.7 100.1 108.6 100.8 118.4 136.1Greece 142.8 142.8 142.8 142.8 142.8 142.8 142.8 142.8Ireland 96.2 96.2 96.2 96.2 96.2 96.2 96.2 96.2Italy 119.0 124.1 128.0 119.0 119.0 119.0 119.0 119.0Luxembourg 18.4 21.1 23.1 27.8 32.5 1076.2 2133.9 3191.7Malta 68.0 74.4 79.3 90.6 101.8 7112.7 14157.4 21202.0Netherlands 62.7 67.0 70.2 77.8 85.3 137.1 211.5 285.9Portugal 93.0 93.0 93.0 93.0 93.0 93.0 93.0 93.0Slovakia 41.0 47.6 52.7 64.4 76.1 708.6 1376.2 2043.8Slovenia 38.0 43.8 48.2 58.3 68.5 1258.2 2478.3 3698.5Spain 60.1 65.0 68.8 60.1 60.1 60.1 60.1 60.1

The original EFSF entails total guarantees amounting to €410bn (€440bn minus guarantees from Greece, Portugal, and Ireland), with effective lending capacity of €255bn. The amended EFSF (to be ratified in September) entails total guarantees amounting to €726bn (€780bn minus guarantees from Greece, Portugal, and Ireland), with effective lending capacity of around €450bn. The doubled and tripled pro rata EFSF options double and triple the amended EFSF guarantees respectively (although they do not entail Spain and Italy taking on any guarantee obligation). The joint and several guarantee scenarios entail sovereigns taking on jointly guarantees of €440bn, €880bn, and €1,320bn respectively (Spain and Italy do not take on any guarantee obligations in these scenarios either).

Exhibit 12: ECB’s SMP program € bn, both scales

0

5

10

15

20

25

May

10

Jun

10

Jul 1

0

Sep

10

Oct

10

Nov

10

Jan

11

Feb

11

Apr 1

1

May

11

Jun

11

Aug

11

Sep

11

0

50

100

150

Weekly purchases

Outstanding amounts

Exhibit 11: Excess reserves at the ECB € bn

-100

0

100

200

300

400

Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11

Start of tenders w ith full

allotment at fix ed rates

1-y ear refis



40

The ECB will have to play a critical role

Alongside an enlarged and more active EFSF, the ECB will be the other key institution working to limit the broader damage to the region. In response to the stresses caused by the sovereign crisis, the ECB is already using its balance sheet to provide liquidity to both banks and sovereigns. The need for this liquidity support is likely to rise significantly, which means that the central bank’s balance sheet will grow to a much greater extent than was seen even at the height of the financial crisis.

Since October 2008, the ECB has been meeting banks’ liquidity needs in full. In late 2008, this led to a doubling of the total loans made by the ECB to banks to €900bn, as the central bank stepped in to replace the interbank market as the re-distributor of liquidity from banks with surpluses to those with deficits. Alongside the offer of unlimited funds, the central bank broadened the collateral pool and extended the maturity horizon. The stresses over recent weeks have prompted the central bank to reintroduce a 6-month tender in euros, which was previously available from April 2008 to May 2010, and a 3-month tender in dollars, previously available in May 2010. Given the repercussions of a harder Greek debt restructuring, the central bank will need to offer unlimited liquidity provision to banks for a very long period, and they may need to revisit their collateral requirements and extend the maturity of their operations back out to 12 months (the last 12-month tender was in December 2009). But, there is little doubt that the central bank will act as the lender of last resort to the banking system for as long as is necessary.

More uncertainty relates to the other dimension of ECB support, outright purchases of assets. From mid-2009 to mid-2010, the ECB bought €60bn of covered bonds to support this important bank funding market. And, more controversially, through the Securities Markets Program, set up in May 2010, the central bank has bought around €158bn of peripheral government bonds. It seems that for much of the time that the SMP has been in existence, the central bank has been driving with the hand brake on. There are four interrelated reasons for this. First, the central bank is very aware of moral hazard. It is concerned that its intervention in government bond markets would ease the pressure on sovereigns to take difficult fiscal decisions. Second, there are concerns about the medium-term consequences—whether for

future financial stability or inflation, especially if the fiscal authorities failed to adjust. Third, there is concern about the credit risk that the central bank is incurring and what purchases might mean for its capital. And fourth, there is the question of political legitimacy—the independent central bank is being drawn into the difficult area of fiscal policy.

Despite these concerns, the central bank will continue to purchase peripheral debt to limit the increase in bond yields. Its stated hope is that the EFSF will be able to take over these interventions when parliaments have ratified the July 21 agreement, but in our view this hope will be disappointed. Only if the EFSF is turned into a bank will the ECB be able to stop these direct interventions. But, even if this happens, the central bank’s balance sheet could still grow dramatically. It would not be surprising if support to sovereign bond markets ultimately reached €1,000bn. In addition to ongoing support to government bond markets, the ECB could resume its support for private sector credit markets, either directly or indirectly via the EFSF.

Alongside these unconventional measures, the ECB is likely to ease its conventional monetary policy stance. Our expectation is that it will reverse the two hikes of earlier this year, and will put the policy rate at 1%. But, with unlimited liquidity provision, the actual overnight will be a lot lower, at just above the marginal deposit rate, which we expect to be at 25bp.

Does a Greek default lead to EMU exit?

The decision on future financing will be taken by Greece’s official creditors—the decision on whether to remain in the euro area will be taken by Greece. There is no legal reason why a second, harder debt restructuring would lead to a Greek exit from EMU, but for many commentators these developments are tightly linked. Essentially this decision involves a judgement about the trade-off between certain near-term costs and uncertain medium-term benefits.

The case for EMU exit alongside a default runs as follows. Exiting the euro area would give Greek policymakers the option of printing money to finance the deficit, which would limit the amount of fiscal consolidation that would be needed. Even in the absence of such explicit monetary financing of the deficit, the



41

newly introduced Greek currency would fall sharply against the euro, improving Greek competitiveness and boosting exports at the expense of imports. Those who argue that the roots of the Greek crisis lie in its loss of competitiveness within EMU have often suggested that Greece needs to exit the single currency in order to “reset” its level of prices and costs relative to the rest of the region.

The case against an EMU exit rests on the idea that the near-term costs are pretty certain and are likely to be large, while the benefits are more medium-term and are more uncertain.

In addition to the disruptive impact of default, EMU exit would add enormously to the financial shock within Greece itself. Holders of Greek assets would seek to protect their wealth by moving into assets that would be protected from redenomination into a weaker currency. Even previously immobile capital would exit Greece rapidly. Controls on capital movement and restrictions on the withdrawal of deposits from banks would need to be imposed. It is unlikely that the rest of the region would continue to support Greece in the event of EMU exit, although the quid pro quo could be a Greek default on the official loans. Given the slow pace of democratic processes, it is unlikely that a currency change could be announced quickly enough to prevent this severe near-term disruption. Establishing legal jurisdiction over consequent gains and losses would likely take years, creating uncertainty in the meantime. And, introducing a new currency creates a host of logistical problems with getting a new physical means of exchange into place. It seems pretty clear that the near-term disruption caused by EMU exit would be large.

Meanwhile, the medium-term gains are very uncertain. Competitiveness will only be boosted if nominal wages do not rise in step with gains in import prices. Admittedly, emerging markets have often benefited significantly from a post-default currency decline. But, amid a big shake-up in the distribution of income, workers in a highly rigid economy like Greece would likely fight to prevent their living standards from being eroded, which would limit the gains from a lower currency. Meanwhile, the benefits of monetary financing would be limited if inflation expectations and inflation were to rise sharply.

The consequences of a Greek exit for the rest of EMU would be profound. A Greek exit would demonstrate that the use of the euro was not irrevocable, which would likely trigger a fundamental reappraisal of the value of all debt in the region, as markets moved to price in the possibility of Euro area exit by other stressed sovereigns. It is very likely that exit by one country would cause massive flight of bank deposits from the periphery toward Germany and its neighbors, and a collapse in asset prices across the region as a whole. As the majority of Greece’s exports go to the rest of the Euro area, the impact on the rest of the region is important to Greece itself.

Greece and EMU’s existential crisis

Since the start of the euro area sovereign crisis 18 months ago, policymakers have sought to keep the rescue mechanisms limited in scope, temporary in nature, and intergovernmental in structure. And, they have laid out a vision for the next steady state beyond the crisis, which has a governance structure similar to the first decade of EMU, but stronger—a tougher and broader intergovernmental Stability and Growth Pact, and a “no bailout” sanction reinforced and strengthened by the new ESM treaty.

However, most commentators and market participants have concluded that the approach adopted so far is doomed to fail—that the region will soon face a choice between fiscal union (with common Eurobonds) and EMU breakup. This suggests that, relative to the approach adopted so far, policymakers will need to move to something more permanent and supranational in order to keep the monetary union intact. In our view, that is too stark a characterization of the near term. Policymakers do recognize the need for more substantial action, but they will still aim to keep the rescue mechanisms temporary in nature and intergovernmental in structure.

However, the current crisis is forcing the region to confront some difficult questions about its future; essentially, does there need to be a much greater degree of political and fiscal integration in order to ensure the survival of the monetary union? In our view, the preparations for a second, harder debt restructuring in Greece will provide the region with the breathing space that it needs to have a debate about its future—a more active EFSF and ECB can contain market pressures as



42

the debate unfolds. And, these mechanisms will be needed. Although the ultimate destination of a greater degree of political and fiscal union with common bonds would eliminate much (or all) sovereign risk in the region, the road to that destination is likely to be a rocky one, if such a destination can be reached at all. There will surely be plenty of disagreement and confusion, a perfect recipe for market volatility. But, our view remains that as policymakers are forced to choose between more integration or less, they will likely continue to choose the former.


Srini RamaswamyAC J.P. Morgan Securities LLC

43

Forecasts & Analytics

Interest Rate Forecast

Swap spread forecast*

Sep 23, 2011 Oct 23, 2011 Dec 31, 2011 Mar 31, 2012 Jun 30, 2012 Sep 30, 2012

1m ahead 4Q11 1Q12 2Q12 3Q12

Rates Forecast Forecast Forecast Forecast Forecast

Effective funds rate 0.08 0.08 0.10 0.10 0.12 0.12

3-month Libor 0.36 0.45 0.40 0.40 0.30 0.30

3-month T-bill (bey) 0.00 0.00 0.03 0.03 0.15 0.15

2-year T-note 0.22 0.25 0.30 0.30 0.35 0.35

5-year T-note 0.85 0.80 1.15 1.30 1.45 1.45

10-year T-note 1.81 1.70 2.25 2.60 2.80 2.80

30-year T-bond 2.87 2.90 3.50 3.80 4.00 4.00

Curves

3m T-bill/3m Libor 36 45 37 37 15 15

2s/5s 63 55 85 100 110 110

2s/10s 159 145 195 230 245 245

2s/30s 265 265 320 350 365 365

5s/10s 96 90 110 130 135 135

5s/30s 202 210 235 250 255 255

10s/30s 106 120 125 120 120 120

* Fed funds assumed to be 0.125% for Fed funds/3m Libor calculation.

Sep 23, 2011 Oct 23, 2011 Dec 22, 2011 Mar 21, 20121 M 3 M 6 M

Forecast Forecast Forecast

2-year sw ap spread 29 29 30 32



30-year sw ap spread -24 -30 -30 -25

*Forecast uses matched maturity spreads



44

Economic forecast

Financial markets forecast

Gross fixed-rate product supply*

Financial markets forecastCredit Spread Current Year-end

2011 Current Year-end

201110Y swap spread* 17 15 S&P* ($) 1130 147530Y current coupon MBS L-OAS** 65 40 Brent** ($/bbl) 105.0 115.010Y AAA 30% CMBS (2007 vintage)** 355 275 Gold** ($/oz) 1692 18003Y AAA Credit Cards fixed** 15 15 EUR/USD 1.35 1.38JULI portfolio spread, ex-EM* 237 250 USD/JPY 76.2 74High Yield Index* 775 650 * S&P500 fo recast

Emerging Market Index* 462 375 ** 4Q11 quarterly average forecast

Corporate Emerging Market Index (Broad)* 497 425* spread to Treasuries

** spread to swaps

0

50

100

150

200

250

300

350

Aug 08 Nov 08 Feb 09 May 09 Aug 09 Nov 09 Feb 10 May 10 Aug 10 Nov 10 Feb 11 May 11 Aug 11

ABS CMBS MBS Corporate Agency

* amount in $ billions

%ch q/q, saar, unless otherw ise noted

10Q4 11Q1 11Q2 11Q3 11Q4 12Q1 12Q2 12Q3 2010* 2011* 2012*Gross Domestic Product Real GDP 2.3 0.4 1.0 1.0 1.0 0.5 1.5 2.5 3.1 0.8 1.7

Final Sales 4.2 0.0 1.2 0.9 1.1 0.3 1.6 2.3 2.4 0.8 1.7

Domestic Final Sales 2.7 0.4 1.1 1.0 1.0 0.1 1.2 2.2 2.9 0.9 1.5

Business Inv estment 8.7 2.1 9.9 5.0 2.8 2.3 2.8 4.6 11.1 4.9 4.3

Net Trade (% contribution to GDP) 1.4 -0.3 0.1 -0.1 0.1 0.2 0.4 0.1 -0.5 -0.1 0.2

Inv entories (% contribution to GDP) -1.8 0.3 -0.2 0.1 -0.1 0.2 -0.1 0.2 0.7 0.0 0.1

Prices and Labor Cost Consumer Price Index 2.6 5.2 4.1 3.2 0.5 0.7 1.2 1.3 1.2 3.2 1.1

Core 0.6 1.7 2.5 2.9 1.2 1.2 1.0 1.2 0.6 2.1 1.1

Producer Price Index 6.5 12.4 7.9 1.2 1.3 1.3 1.5 1.5 3.8 5.6 1.4

Core -0.2 3.7 3.1 3.2 1.0 0.0 1.2 1.2 1.4 2.8 0.9

Employ ment Cost Index 1.8 2.5 2.8 2.5 2.2 2.0 2.0 2.0 2.0 2.5 2.0

Unemploy ment Rate (%, sa) 9.6 8.9 9.1 9.1 9.3 9.4 9.5 9.5 - - -

* Q4/Q4 change



45

Client surveys

DurationLong Neutral Short Changes

Sep 19, 2011 11 74 15 15Sep 12, 2011 11 72 17 153-month average 6 77 17 13

CreditCorporate Bond

WeightingCash

PositionSpread

OutlookSep 8, 2011 1.33 1.00 0.90Jul 14, 2011 1.40 0.67 0.973-month average 1.31 0.82 0.90

*Corporate bond w eighting index is the ratio of the sum of ov erw eights and neutral

positions to the sum of underw eights and neutral positions; the cash position index

is the ratio of the sum of high and medium cash positions to the sum of low and

medium positions; the spread outlook index is the ratio of the sum of positiv e and

neutral outlooks to the sum of negativ e and neutral outlooks.

6 7 8

3 4 5

MBSOverweight Flat Underweight

September 2011 50% 32% 18%August 2011 42% 32% 26%3-survey average 47% 36% 18%

Treasury Client Survey

Credit Client Survey

-30

-20

-10

0

10

20

30

Aug 10 Nov 10 Jan 11 Apr 11 Jul 11 Sep 11

Longs minus shorts

0.8

1.0

1.2

1.4

1.6

1.8

Apr 08 Dec 08 Sep 09 May 10 Jan 11 Sep 11

Corporate Bond Weighting

MBS Investor Survey

-60%

-40%

-20%

0%

20%

40%

60%

Sep

09

Dec

09

Mar

10

Jun

10

Oct 10 Jan

11

Mar

11

Jun

11

Aug

11

Ov erw eight - Underw eight

US Fixed Income Strategy US Fixed Income Weekly New York, September 26, 2011

46

Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this

report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the

research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst’s compensation was, is, or will be directly or indirectly related to the specific

recommendations or views expressed by the research analyst(s) in this report.

Conflict of Interest:

This research contains the views, opinions and recommendations of J.P. Morgan research analysts. Research analysts routinely consult with J.P. Morgan

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US Fixed Income Strategy US Fixed Income Weekly New York, September 26, 2011

Market Movers

26 Sep New home sales (10:00am) Aug 290,000 Dallas Fed survey (10:30am) Sep Governor Raskin speaks on loan servicing in Washington, D.C. (9:15am) St. Louis Fed President Bullard speaks in New York (9:30am) Minneapolis Fed President Kocherlakota speaks on public debt in Chicago (3:00pm)

27 Sep S&P/Case-Shiller HPI (9:00am) Jul 0.3% (-4.2%oya) Consumer confidence (10:00am) Sep 46.5 Richmond Fed survey (10:00am) Sep Auction 2-year note $35 bn Atlanta Fed President Lockhart speaks on the economy in Jacksonville, Florida (12:30pm) Dallas Fed President Fisher speaks on dissent in Dallas (1:20pm)

28 Sep Durable goods (8:30am) Aug 0.3% Ex transportation -0.3% Auction 5-year note $35 bn

Boston Fed President Rosengren speaks in Sweden (2:40am) Chairman Bernanke speaks on EM economies in Cleveland, Ohio (5:00pm)

29 Sep Initial claims (8:30am) w/e prior Sat 425,000 Real GDP (8:30am) 2Q final 1.3% CES benchmark rev. (8:30am) 2011 preliminary Pending home sales (10:00am) Aug -0.5% KC Fed survey (11:00am) Sep Auction 7-year note $29 bn Boston Fed President Rosengren speaks on bank supervision in Sweden (2:50am) Philadelphia Fed President Plosser speaks on the economy in Radnor, Pennsylvania (8:30am) Atlanta Fed President Lockhart speaks in Atlanta (1:00pm)

30 Sep Personal income (8:30am) Aug 0.1% Real consumption -0.2% Core PCE deflator 0.21% (1.7%oya) Chicago PMI (9:45am) Sep Consumer sentiment (9:55am) Sep final 57.5 St. Louis Fed President Bullard speaks in San Diego (11:00am)

3 Oct ISM manufacturing (10:00am) Sep Construction spending (10:00am) Aug Light vehicle sales Sep Richmond Fed President Lacker speaks in Wisconsin (6:00pm)

4 Oct Factory orders (10:00am) Aug Chairman Bernanke speaks to Congress in Washington (10:00am)

5 Oct ADP employment (8:15am) Sep ISM nonmanufacturing (10:00am) Sep

6 Oct Initial claims (8:30am) w/e prior Sat Chain store sales Sep Announce 3-year note $32 bn Announce 10-year note (r) $21 bn Announce 30-year bond (r) $13 bn

7 Oct Employment (8:30am) Sep Wholesale trade (10:00am) Aug Consumer credit (3:00pm) Aug Atlanta Fed President Lockhart speaks on the economy in Atlanta (10:45am)

10 Oct Columbus Day Bond market closed

11 Oct NFIB survey (7:30am) Sep FOMC minutes Auction 3-year note $32 bn

12 Oct JOLTS (10:00am) Aug Auction 10-year note (r) $21 bn

Philadelphia Fed President Plosser speaks on the economic outlook in Philadelphia (1:30pm)

13 Oct Initial claims (8:30am) w/e prior Sat International trade (8:30am) Aug Federal budget (2:00pm) FY11 Auction 30-year bond (r) $13 bn Announce 30-year TIPS (r) $7 bn

Minneapolis Fed President Kocherlakota speaks in Sidney, Montana (2:30pm)

14 Oct Retail sales (8:30am) Sep Import prices (8:30am) Sep Consumer sentiment (9:55am) Oct preliminary Business inventories (10:00am) Aug

“Unless otherwise expressly noted, all data and information for charts, tables and exhibits contained in this publication have been sourced via J.P. Morgan

information sources.”

__________________________________________________________________________________________________________________________

Analyst Certification: The strategist(s) denoted by (AC) certify that: (1) all of the views expressed herein accurately reflect his or her personal views

about any and all of the subject instruments or issuers; and (2) no part of his or her compensation was, is, or will be directly or indirectly related to the

specific recommendations or views expressed by him or her in this material, except that his or her compensation may be based on the performance of the

views expressed.

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JP Morgan's "US Fixed Income Weekly" report 9/26/2011

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