Horizons for a Rebound Corporate-finance implications of recovery scenarios

Transcription

1 FEBRUARY 2009 Horizons for a Rebound Corporate-finance implications of recovery scenarios

2 Marc Zenner (212) Tomer Berkovitz (212) Evan Junek (212) RESTRICTED DISTRIBUTION: Distribution of these materials is permitted to investment banking clients of J.P. Morgan, subject to approval by J.P. Morgan. This material is not a product of the Research Departments of J.P. Morgan Securities Inc. ( JPMSI ) and is not a research report. Unless otherwise specifically stated, any views or opinions expressed herein are solely those of the authors listed, and may differ from the views and opinions expressed by JPMSI s Research Departments or other departments or divisions of JPMSI and its affiliates. Research reports and notes produced by the Firm s Research Departments are available from your Registered Representative or at the Firm s website,

3 HORIZONS FOR A REBOUND 1 1. Recovery horizons matter Strategic decision-makers are coming to grips with a historic financial crisis: substantial wealth losses across most asset classes, record-high volatility and credit risk pricing, historic changes in the financial services industry, and near-zero interest rates. Most of us now understand, with the benefit of hindsight, how valuation uncertainty, collapsing liquidity, excessive leverage, and the interconnectedness of various global markets have led to massive capital losses for investors and financial institutions, credit market contraction, and a global recession. While we cannot capture the magnitude of global wealth losses that include credit, real estate, and commodities, we know that global public equity investors have lost about $30 trillion (or 50%) since the end of To their credit, many of the large global firms adopted financial strategies that have allowed them to weather the crisis so far. With the global growth machine grinding to a halt, unemployment rates escalating, and bank balance sheets under pressure, will these firms be able to weather the next two to three years? Should they pro-actively change their current financial strategies or should they defer action and wait until the worst has passed? A firm s vision about the horizon for a recovery will determine the timing and nature of critical strategic decisions, including financing, shareholder distributions, acquisitions, divestitures, and investments (see figure below). Figure 1 Perspectives on recovery scenarios drive key financial strategy decisions Perspective on recovery Leverage Risk profile Geography Industry sector Liquidity profile Financing Investments Distributions Rapid Wait for better pricing? Once-in-a-lifetime acquisition? Maintain dividend? Unexpectedly prolonged Immediately raise capital? Reduce capex? Suspend buybacks? Source: J.P.Morgan We first examine what previous crises tell us about past recoveries history suggests no strong support for a rapid economic recovery. We then compare expected financing needs to the various sources of capital. This comparison highlights that financing needs are likely to be substantial in , while sources of capital are contracting. Hence, pressures on cost and access to capital are likely to continue in the near term. A firm s decision on EXECUTIVE TAKEAWAY financial strategies always depends on its leaders vision about the future. However, the Understanding the likely horizon of a rebound heightened uncertainty surrounding the next 12 is paramount to making the right strategic to 36 months underscores the importance of decisions today. While we hope for a near-term corporate leaders perspectives today. In a tight credit environment, making the wrong recovery, our analysis of historical precedents decision could lead to disastrous outcomes. and the current situation suggests that Boards Understanding the likely horizons for a rebound should not rely on a rapid near-term recovery is paramount not only for value creation, but when making strategic financial decisions. for survival.

4 2 Capital Structure Advisory & Solutions 2. Possible recovery scenarios While CEOs hope for a rapid recovery, they realize that the recovery may be long and protracted, or even that further economic deterioration could continue to weaken equity and credit markets. As always when the economy is in a downturn, it could improve rapidly, recover slowly, or even get much worse than currently expected. We list catalysts for these three recovery scenarios in figure 2 below. Figure 2 Catalysts for various recovery scenarios Rapid economic recovery Global intervention stabilizes the banking system with large stimulus packages in major countries Too big to fail banks now known De-leveraging of hedge funds and brokerage firms mostly complete Cash going back into risky assets and bringing back liquidity Real estate prices recover rapidly Large emerging markets provide engine for growth Lower energy prices, interest rates, and taxes stimulate consumer demand Source: J.P.Morgan Protracted economic recovery Government financing competes with private sector financing needs Bank balance sheet contraction continues Further de-leveraging of hedge funds and brokers Continued investor conservatism Real estate market takes several more years to recover Full effect of global crisis starting to impact emerging markets Consumers bolster savings while household balance sheets are de-leveraged Economic deterioration beyond expectations Unintended consequences of government interventions erode liquidity and faith in markets Additional large bank failures Collapse of hedge funds and brokers Investors stay in cash because of ongoing uncertainty Real estate market continues to crumble; individuals and corporations suffer crippling long term value loss Most fragile economies require global intervention Unemployment and food shortages create political unrest in geopolitically important regions Rapid recovery: Thankfully, there are some powerful catalysts for a rapid recovery. Governments worldwide have made recovery their absolute priority, taking action to recapitalize banks and stimulate the economy with aggressive fiscal measures. Previous bank crises lacked this type of aggressive intervention. By supporting financial institutions that are deemed too important to fail, governments are reducing the anxiety of firms and individuals dealing with these major financial institutions. Government intervention is also focused on stabilizing the real estate market, which is critical to support consumer demand. Together with tax cuts and government spending, low energy prices and low interest rates may provide enough impetus to boost businesses and consumer demand. In addition, the de-leveraging of hedge funds and brokers, which has extracted significant capital from the financial system, is hopefully almost over.

5 HORIZONS FOR A REBOUND 3 Protracted recovery: Unfortunately, many catalysts of the financial crisis could be associated with a protracted recovery. Real estate markets that have not found the bottom are worrisome real estate constitutes a major part of the wealth of most consumers and many other sectors are impacted by the housing market. In the absence of a clear bottom in real estate and equity markets, investors may prefer to hold onto cash and delay their return to riskier assets, thereby keeping the risk premiums high. Rising unemployment levels may also continue to weaken the real estate market and consumer demand, leading to further increases in bank write-downs. Combined with a desire to achieve more defensive capital structures and uncertainty about future asset values, these write-downs may spur further bank balance sheet contraction. Moreover, governments with sizable financing needs will compete with the private sector for investor interest, which, in turn, could lead to higher Treasury rates and upside pressure on the cost of capital. Figure 3 Financial implications of the various recovery scenarios Rapid economic Protracted economic Economic deterioration recovery recovery beyond expectations Cost of capital Capital availability Asset values Economic opportunities Cash flows Source: J.P.Morgan Economic deterioration beyond current expectations: There are also some scenarios in which the economy deteriorates beyond today s already pessimistic expectations. This could further damage frail financial markets. Possible catalysts for this scenario include the unintended and still unknown consequences of massive global government intervention. In a complex and interconnected economy, major government interventions carry the risk of long-term negative effects. Other risk factors include recessions in some of the emerging markets, which are currently still in a growth mode. Some of the more pronounced downside scenarios include political turmoil in major economies. While political turmoil is always a possibility, it may be more likely if unemployment levels increase unusually quickly, financial markets plummet further, and food prices increase because of weak currencies, low inventories, or poor agriculture production. EXECUTIVE TAKEAWAY The success of financial strategies will depend on the recovery scenarios which will unfold. In light of today s uncertainty, decision-makers should consider a wide range of outcomes when planning for the next few years.

6 4 Capital Structure Advisory & Solutions 3. The historical perspective What can senior executives learn from the recovery horizons of the many crises that have occurred over time? While most of us are surprised by the extent of the current crisis, there have been several crises following the collapse of bubbles. When examining historical data, we should take into account that every crisis is unique and that the world is different today. History suggests, however, that recoveries following major bank crises have been slow and associated with long periods before asset prices returned to their pre-crisis levels. Major historical bank crises: We first compare the observations of a recent academic study 1 to the current credit crisis. Based on 15 bank crises (all but two are post-world War II), the authors of the study find that, on average, housing prices fell 36% from peak to trough, while equity prices fell 56%. With a 29% decline in house prices and a 53% decline in equity markets in the US, the current crisis seems comparable to the typical bank crisis in this study. The data suggest, however, a potential further deterioration in unemployment and GDP. It is disconcerting that the average duration of the peak-to-trough movement of previous crises has been long relative to the duration of this crisis. This comparison suggests that a near-term recovery would make this crisis a relatively mild one compared to previous bank crises. The usefulness of this historical analysis is that it studies historical bank crises that are quite comparable based on the sequence of events and several key metrics to the crisis we are currently experiencing. A weakness of the comparison is that most of these crises were confined to one country or region. The Scandinavian or Asian countries where bank crises occurred benefited from the strength of the rest of the world to stimulate their export and/or provide capital. By contrast, today s crisis is global, with few economies having been unaffected. Figure 4 Depth and duration (peak to trough) of recent major bank crises Percent change Duration in Years History average Current crisis History average Current crisis Housing prices 1-36% -29% Equity values 2-56% -53% Unemployment rate 3 7.0% 3.2% GDP per capita -9.3% -1.5% Public debt 4 86% 16% Source: Reinhart and Rogoff (2008) The aftermath of Financial Crises, Bloomberg, J.P. Morgan Note: Changes in housing prices, equity prices, GDP, and public debt are presented in real terms (CPI deflated) Historical bank crises include: Malaysia (97), Thailand (97), Korea (97), Argentina (01), Sweden (91), Japan (92), Norway (87), Spain (77), Indonesia (97), Finland (91), Colombia (98), Philippines (97), and Hong Kong (97), US (29) and Norway (1899) 1 Change in real housing prices. Current US crisis change is based on the Case-Shiller Home Price Index 2 Change in real equity prices. Current US crisis is based on the S&P 500 index 3 In percentage points 4 Change in real public debt. Current crisis: change in the US public debt is from Dec 2007 to Dec Reinhart and Rogoff (2008), The aftermath of Financial Crises.

7 HORIZONS FOR A REBOUND 5 Lessons from Japan s 1990s crisis: Many market commentators look at Japan s 1990 crisis to understand the potential consequences of the current crisis. Japan s upsurge in the late 1980s was driven by booming real estate and equity markets. Banks considered mortgage loans to be low-risk and investors developed an appetite for risky securities. When the bubble collapsed, Japan organized a $400bn bank bailout, adopted a zero interest-rate policy, and flooded the market with liquidity. These measures did not, however, suffice to re-establish the Japanese real estate and equity market. To date, the equity market is still only about a quarter of its peak level (figure 5). Figure 5 Tokyo stock market index vs. S&P 500 and the MSCI world index Tokyo S&P Source: J.P.Morgan MSCI World Index Japan s recovery has been slow because the government initially underestimated the nature and seriousness of the crisis. 2 The belief that the financial system s ills could be resolved through economic growth and low interest rates resulted in delayed action. Furthermore, the magnitude of non-performing loans was poorly understood and the severity of this problem was revealed only when reporting requirements changed. As a result, many of the rescues of ailing financial firms by healthier financial institutions required a government injection of capital in some form. Many believe that the bubble preceding the bank crisis in Japan was more severe than the one preceding the current, global bank crisis. Nevertheless, an important lesson from Japan is that early and decisive government action may reduce the length of the recovery period. 3 Figure 6 NYSE from the 19th to early 20th century Years from peak to Average annual return Crisis trough recovery depth (10 years from trough) (26%) 9% (32%) 27% (21%) 26% (14%) 27% (29%) 14% (12%) 22% (22%) 10% (11%) 4% Average (21%) 17% Source: Goetzmann, Ibbotson and Peng (2000), A New Historical Database for the NYSE 1815 To 1925: Performance and Predictability 2 Dick Nanto (2008), The U.S. Financial Crisis: Lessons from Japan, Congressional Research Service (CRS) report. 3 Masahiro Kawai (2005). Reform of the Japanese Banking System. International Economics and Economic Policy.

8 6 Capital Structure Advisory & Solutions Pre-1929 bank crises in the US: Newly available data on stock performance starting from the beginning of the 19th century 4 allow us to examine the depth and duration of previous bank crises in the US from an equity valuation perspective. In figure 6, we see that the average duration from peak to trough was two-and-a-half years, while it took almost five years on average for stock prices to return to pre-crisis levels. On average, stocks fell by at EXECUTIVE TAKEAWAY least 21% from peak to trough (this is likely to be History suggests that major bank and financial underestimated as we have only end-of-year data). Consistent with higher investor riskaversion during crises, the average annual return crises tend to be associated with significant and long-lasting economic weakness. While each in the ten years following the crises was 17%. crisis is unique, the historical perspective suggests that executives should not dismiss the possibility of a long recovery and a further severe contraction in the economy. 4. Sizable capital needs The US government: The US government has been a major contributor of funds to various sectors in need of liquidity and/or capital, in particular to the banking, insurance, and auto sectors. Because of these capital injections as well as a major stimulus plan that includes tax relief, we estimate the US government will have to issue $1.7 to $2.0 trillion in 2009 (figure 7) in coupon debt (Treasury bonds) alone (estimates including short-term Treasury debt top $2.2 trillion). By comparison, the US government issued about $700 bn of Treasury bonds on average over the preceding five years. Issuances about two-and-ahalf times higher than the previous five-year average will compete for capital with the private sector. Figure 7 US Treasury Coupon Issuance ($bns) year average ~2.5x historic average Source: Bloomberg; J.P.Morgan 1 J.P. Morgan estimates as of 1/9/09 The bank sector: Bank balance sheets have been under pressure since the crisis began in the summer of In figure 8, we show that with more than $800bn in write-downs to date and an average tier 1 capital ratio of 8.1% at the beginning of the crisis, the asset base of the 75 largest global banks and brokers would have contracted by almost $10 trillion in 4 Goetzmann, Ibbotson and Peng (2000), A New Historical Database for the NYSE 1815 To 1925: Performance and Predictability

9 HORIZONS FOR A REBOUND 7 the absence of over $800bn of private sector and government capital infusions, which have offset these write-downs. Banks are, however, under pressure from investors, clients, and regulators to adopt more conservative capital ratios. This pressure comes in part from their need to be protected from the uncertainty of potential future write-downs and from the need to de-lever when market and economic uncertainty is high. For example, if all large banks raised their capital ratio from 8.1% to 10%, their aggregate asset base would contract by almost $9.5 trillion in the absence of further capital infusions. Figure 8 Global bank balance sheet erosion ($bns) $4,600 ($10,100) $5,900 ($9,400) $49,300 Reduction in capacity of about $4 trn before government injections $45,100 $49,700 Capacity further reduced at 10% capital ratio $40,300 Asset base Impact of $815bn in write-downs Impact of raising $480bn of private capital Asset base (PF private capital raises) Impact of Asset base raising (PF all capital $374bn in raises) govt capital Impact of delevering at 10% Source: Bloomberg; J.P.Morgan Note: Total write-downs and capital raised as of 2/10/09 ¹ Includes the 75 largest global banks/brokers by write-downs; Assumes core capital ratio of 8.1% Asset 10% cap ratio In figure 9, we show the interaction between future additional write-downs and target capital ratios. If banks incur no additional write-downs and target a 10% tier 1 ratio, then they would have to raise about $940bn of capital to maintain the size of their pre-crisis balance sheet. If bad economic conditions lead to another $500bn of write-downs (in line with many estimates) then they would need $1.4 trillion in additional funds to maintain the same asset base. This estimate, for tier 1 capital, is well in excess of the capital banks have raised thus far. These firms will also have to raise significant amounts of debt financing during the same period (for example, to refinance upcoming debt maturities). Figure 9 Capital needed to maintain asset base Target capital ratio Additional write-downs ($ bn) $0 $250 $500 $750 $1, % $0 $250 $500 $750 $1, % $440 $690 $940 $1,190 $1, % $940 $1,190 $1,440 $1,690 $1, % $1,430 $1,680 $1,930 $2,180 $2, % $1,920 $2,170 $2,420 $2,670 $2,920 Note: Assumes starting capital ratio of 8.1% and estimated asset base of $49.3trn

10 8 Capital Structure Advisory & Solutions Figure 10 Capital requirements for high yield firms ($bns) Maintain balance sheet cash (0% used) Scenario 1 (-10% FCF) Deploy 25% balance sheet cash to pay maturities Scenario 2 (-20% FCF) Deploy 50% of balance sheet cash to pay maturities 2008 HY Issuance Scenario 3 (-30% FCF) Source: Factset, J.P.Morgan. Excludes financial and utility firms. Note: Capital requirement defined as 2008LTM free cash flow + balance sheet cash (dividends maturities). Does not include pension expenses. Maintain balance sheet cash, aggressive, and extreme cash use indicate 0%, 25%, and 50% of balance sheet cash used, respectively. Scenarios 1,2, and 3 indicate a drop in free cash flow of 10%, 20%, and 30% relative to 2008LTM figure respectively. Free cash flow defined as OCF capex. Figures presented represent the sum of all capital deficits only which represents, in the worst case, 202 (43%) of the 472 firms in the sample Non investment grade firms: Non-finance firms will also have significant capital needs in To gauge the potential needs of non-investment grade firms in the Russell 3000 index, we assume various shocks (10%, 20%, 30% declines) on 2008 cash flow. In addition, we assume a moderate to aggressive use of on-balance sheet cash to cover cash-flow needs. We use the firms funds to finance dividends (which we keep unchanged), capital expenditures, and 2009 bond maturities. Results show that with a 30% decline in cash flow, about 40% of these firms could suffer a significant financing deficit, which would aggregate to over $125bn. To put this in perspective, in 2008, high-yield issuance was about $53bn, and the vast majority of this issuance occurred in the first half of the year. In the absence of a recovery in the high-yield market, these firms will have to resort to (1) dividend cuts, (2) equity and equity-linked issuances (public or private equity), (3) more significant cuts in capital expenditures, (4) asset sales, and/or (5) combinations with acquirers with stronger balance sheets. Consumers: It is difficult to ignore the role of the consumer in molding the current credit crisis. In figure 11, we highlight some of the key trends relating to consumers in the US since We show that consumption as a percentage of GDP stagnated around 62-64% for the first half of the period, and then gradually increased to slightly over 70%. As a mirror image to the consumption increase in the early 1980s, the US savings rate started dropping from about 10% in the early 1980s to about 0% over the last few years. At the same time, household debt increased, in particular since the end of the 1990s, and real estate peaked to over 35% of household net worth. Ironically, the consumer s likely desire to increase savings and reduce household debt, which is a favorable trend from a capital perspective, EXECUTIVE TAKEAWAY is likely to be associated with a decline in Demand for capital by governments, banks, and consumption as a percentage of GDP. The latter the rest of the private sector may be substantial is an unfavorable trend for those relying on consumer demand to boost the economy. relative to historical norms. Will the supply of capital be able to absorb this demand?

11 HORIZONS FOR A REBOUND 9 Figure 11 Consumer debt has increased with spending Consumption as % of GDP Household debt to net worth ratio US household savings as % of disposable income LEFT SCALE 75% 70% 65% 60% 55% RIGHT SCALE % 35% 30% 25% 20% 15% 10% 5% 0% -5% Source: Bureau of Economic Analysis, Federal Reserve 5. A dwindling capital supply It is virtually impossible to measure the effect of this crisis on the supply of near-term capital. Almost all asset classes have declined in value; from real estate to bonds, and from art to commodities, investors have incurred massive value loss. For example, in public equity alone investors lost about $30 trillion dollars, or 50%, in This massive wealth loss could affect market participants investment behavior, risk-aversion, pricing for risk, and preference for liquidity. We focus on banks, hedge funds, and mutual funds key intermediaries and providers of liquidity in today s markets. Bank balance sheet contraction: In the previous section, we showed the interaction between write-downs, capital raises, and tier 1 capital ratios. Not surprisingly, write-downs and higher capital ratios lead to bank balance-sheet contraction, while new capital offsets this effect. Bank balance sheets will continue to be under pressure until bank executives have greater certainty about the likely size of future losses they may incur. Higher tier 1 capital ratios provide a buffer against write-downs, while removing the riskiest assets from the balance sheets reduces the uncertainty about future write-downs. In figure 12, we show that with additional expected losses in the range of $0.5 to $1 trillion, and the desire to achieve more conservative tier 1 ratios, bank balance sheets would contract significantly in the absence of further capital raises. For example, if banks write down another $500bn without offsetting capital raise, and target a 10% tier 1 ratio, then their balance sheets would contract by an aggregate amount of about $14.4 trillion. As we stated before, governments worldwide are focused on the important economic role of banks. We therefore believe that governments will continue to contribute capital to offset the contraction pressures whether via direct capital injections or isolation of the toxic bank assets. Bank balance sheets will, however, remain under pressure.

12 10 Capital Structure Advisory & Solutions Figure 12 Balance sheet contraction without additional capital raises to offset write-downs 1 Target capital ratio Additional write-downs ($ bn) $0 $250 $500 $750 $1, % 0 3,090 6,170 9,260 12, % 4,930 7,710 10,490 13,260 16, % 9,370 11,870 14,370 16,870 19, % 13,000 15,270 17,540 19,820 22, % 16,020 18,110 20,190 22,270 24,360 Note: Assumes starting capital ratio of 8.1% and estimated asset base of $49.3trn Source: J.P. Morgan 1 The new balance sheet is calculated as follows: (current tier 1 capital additional write-downs )/target leverage. Hedge funds: Hedge fund capital has been an important factor in many of the asset classes that have been most affected by the credit crisis. Hedge funds played a significant role in the liquidity of equity, convertible bonds, CDS, CDOs, CLOs, commodities, and loans. Today, hedge fund buying power has shrunk substantially for the following reasons: (1) Declining asset values: Like other asset classes, hedge funds experienced significant losses last year leading to declines in assets under management. (2) Redemptions: Investors have made sizable redemptions from hedge funds. Poor performance drove much of the redemption demand in addition to investors own liquidity needs to meet cash calls. Hedge funds have also liquidated assets in anticipation of additional redemptions. (3) Reduced leverage: Because of increased conservatism and the rising volatility and illiquidity in the value of collateral, prime brokers who provide leverage to hedge funds have tightened collateral requirements and increased pricing. These factors have increased the cost and lowered the capacity of leverage. (4) Reduced access to existing lending facilities: Declining assets under management have triggered some clauses that have further reduced hedge-fund access to term-lending facilities. In figure 13, we show how one academic 5 estimates that aggregate hedge-fund market positions have potentially dropped from over $5.2 trillion in 2007 to about $3.7 trillion a year later. Assuming further redemptions (20%) and de-levering (to 2.0x) in 2009, the hedge-fund market position could drop to $2.6 trillion. Many hedge funds have limited redemptions and also own hard-to-value assets, so there is likely to be continued (lagged) contraction in hedge-fund buying power. 5 Hedge Funds, Systemic Risk, and the Financial Crisis of , Written Testimony of Andrew W. Lo to the U.S. House of Representatives

13 HORIZONS FOR A REBOUND 11 Figure 13 Hedge funds will de-lever, consolidate, and become smaller Assets (in $bn) 6,000 5,000 4,000 3,000 2,000 1, x leverage Estimated assets 2.7x 2.4x 3.5x 3.0x 2.4x x 2.8x Market positions 2.3x 2.3x 2.0x (Proj.) (delever) Source: Andrew Lo s testimony to the U.S. House of Representatives (based on an HFR industry report) and 2009 estimates by J.P. Morgan Mutual funds: In figure 14 we show how mutual-fund flows have moved from riskier asset classes to safer ones as investors expressed their preference for liquidity and capital preservation. Outflows from equity open-end funds were over $190bn, more than the inflows of 2006 and 2007 combined. Bond inflows dropped sharply from $136bn in 2007 to $34bn in At the same time, money market inflows continued to be strong, albeit at lower levels than the 2007 inflows. Figure 14 Mutual fund flows have moved from equities and bonds into money markets ($bn) $720.4 $687.7 $315.1 $96.7 $113.2 $61.9 $66.1 $72.9 $136.3 $34.1 $97.7 ($190.4) Equities Corporate Bonds Money Markets 2008 Source: AMG Data Services, excludes ETFs EXECUTIVE TAKEAWAY Investors/consumers have incurred massive losses worldwide. How will this change their view on liquidity, risk tolerance, and consumption? Individual investors will need to re-assess their investment objectives. The lending or buying power of important institutional providers of liquidity banks, hedge funds, and mutual funds is severely contracting as a result of the credit crisis. Boards should assume that the supply of risk capital may be severely impaired for the next few years.

14 12 Capital Structure Advisory & Solutions 6. Action plan for key executives Evidence from other bank crises, sizable capital needs, and a diminished capital supply suggest that the road ahead may be challenging. While there are some catalysts for a rapid recovery, most of the evidence suggests that a rapid recovery is not the most likely scenario. In the presence of significant continued uncertainty about the economy and access to capital, senior executives and Boards should continue to focus on liquidity and balance sheet strength, and take advantage of windows of opportunity as they arise. We propose the following recommendations: Preparing for downside scenarios 1. Scenarios assuming a rapid recovery should not constitute the base case for financial planning. While there are some catalysts for a rapid recovery, firms should also consider severe downside scenarios. 2. Downside scenarios should not be based on recent history. Instead, firms should incorporate the experiences of previous bank crises on unemployment and economic growth and consider previously unthinkable downside shocks. 3. With higher leverage and volatility, outcomes will be asymmetric. Hence, making a decision that turns out to be wrong amidst a further downturn will be more detrimental than making a decision that appears to be wrong in a rapid recovery. Capital management 4. Boards should not look back from a pricing perspective. Early 2007 credit or equity pricing (when credit was historically inexpensive) will not be relevant for near-term financing decisions. 5. Boards should not exclude any financing alternatives. While not all alternatives are appropriate, it is imprudent to exclude alternatives when all markets have become less certain. 6. Liquidity and access to capital will continue to trump EPS accretion and tax savings for the foreseeable future. 7. Firms should consider strategic combinations to enhance liquidity and access to capital, whether through cost savings, scale and diversity, or pricing power. Strategic management 8. Inaction does not equate to conservatism. Boards should re-assess their financial strategies in the context of today s environment. Being conservative in some cases requires pro-active moves. 9. Senior management should keep the Board informed on a regular basis about access to capital, contingency scenarios, and liquidity assessment. 10. Firms should contemplate how government intervention and regulation could affect their business and broader industry. Figure 15 Perspective on recovery drives corporate strategy Rapid economic Protracted economic Economic deterioration recovery recovery beyond expectations Financing Hold / Raise Raise Raise Investments Grab market share Cautious /cost Sizable capacity saving mergers reduction Distributions Hold Cut Cut aggressively Source: J.P. Morgan

15 We would like to thank Ben Berinstein, Phil Bleser, Emily Brodeur, Cassio Calil, Thomas Hagerstrom, Chris Harvey, Jeremy Hill, Brian Keegan, Chris Kunhardt, Nishant Mago, David Seaman, Mark Shifke, Rama Variankaval, and Steve Wolf for their invaluable comments and suggestions. We would like to thank Jessica Vega, Jennifer Chan, Anthony Balbona, and the IB Marketing Group for their help with the editorial process and are very grateful to Andy Chi and Benjamin Burdett for their valuable insights and assistance with the analytics in this report. We would also like to thank Professor William Goetzmann for access to historical stock return data. RESTRICTED DISTRIBUTION: Distribution of these materials is permitted to investment banking clients of J.P. Morgan, only, subject to approval by J.P. Morgan. These materials are for your personal use only. Any distribution, copy, reprints and/or forward to others is strictly prohibited. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively JPMorgan Chase & Co.) do not warrant its completeness or accuracy. Information herein constitutes our judgment as of the date of this material and is subject to change without notice. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. In no event shall J.P. Morgan be liable for any use by any party of, for any decision made or action taken by any party in reliance upon, or for any inaccuracies or errors in, or omissions from, the information contained herein and such information may not be relied upon by you in evaluating the merits of participating in any transaction. J.P. Morgan is the marketing name for the investment banking activities of JPMorgan Chase Bank, N.A., JPMSI (member, NYSE), J.P. Morgan PLC (authorized by the FSA and member, LSE) and their investment banking affiliates. IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties. Copyright 2009 JPMorgan Chase & Co. all rights reserved.

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