Credit Questions Subprime Woes Redefine the Fixed-Income Markets

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1 August 2007 Credit Questions Subprime Woes Redefine the Fixed-Income Markets > Continued weakness in the subprime-mortgage market has created widespread turmoil in bond markets > This appears to be a correctable problem driven by temporary liquidity problems > Credit markets are still choppy, but we also see new opportunities, which investors should approach with caution Research Insights Investment Products Offered Are Not FDIC Insured May Lose Value Are Not Bank Guaranteed Investments

2 Glossary The subprime-mortgage problem and its effects have filled the headlines for some time now, and much of the discussion includes complex terminology. Here are a few definitions to keep in mind as you read on. Collateralized Debt Obligation (CDO) A fixed-income security created by pooling together similar types of bonds or loans, such as corporate bonds (called collateralized bond obligations), commercial bank loans (collateralized loan obligations) or mortgage-backed securities (collateralized mortgage obligations). A CDO repackages the cash flows from the pool of assets (the collateral) into tranches with different maturities, cash flows and risks. (See Tranche.) Liquidity How easily investors can buy or sell an asset. With liquid assets, there tends to be less difference between the price that a seller demands and the price a buyer is willing to pay, and investors can easily buy or sell these assets. With less liquid assets, the difference in prices tends to be larger, making these assets harder to buy or sell. Securitization The process of creating a security that trades in financial markets by packaging a pool of underlying income-generating assets, such as loans or mortgages. Through securitization, issuers can remove the original assets from their balance sheets, allowing them to use the proceeds for other purposes. This process also allows investors to better diversify risk. Tranche When issuers package a group of underlying assets into securities through securitization such as with a collateralized debt obligation (CDO) or collateralized mortgage obligation (CMO) the new security is divided into tranches, each of which has its own risk/return profile and trades separately from the others.

3 A Summer of Turmoil Headlines screamed about defaulting mortgages, teetering hedge funds, market blowups and multi-billion-dollar losses, as a summer that started with record-breaking equity markets and historically low volatility unraveled. So Many Questions The tremors first appeared in some segments of the U.S. bond market, but the volatility quickly spread across the globe. As a result, financial advisors have been in overdrive trying to reassure their clients. Recent events have also left financial advisors with plenty of questions of their own: > How will all of this affect the U.S. economy and the stock market? > Will it prompt a recession? > Will it encourage the Federal Reserve to ease interest rates? > Are banks in danger? > Will it derail corporate growth? > Does it present any new investment opportunities? The Bottom Line: A Temporary Problem for Most Bond Markets We believe that weakness in the housing market will continue to impact the subprime-mortgage market and other highly structured securities. But fundamental strength continues to support many other segments of the bond market, reducing the turbulence to a temporary and correctable problem. In some respects, this may be a welcome readjustment in credit risk spreads, which had veered far below their long-term averages. Credit markets are still unsettled, but we believe the financial world isn t about to collapse. In fact, economic fundamentals remain sound, and we even see opportunities in the markets that didn t exist a few weeks ago. > How safe are my clients bond portfolios? Subprime woes may continue, but for most bond sectors, the recent uproar stems from temporary and correctable liquidity problems.

4 Credit Questions: Subprime Woes Redefine the Fixed-Income Markets A History: Subprime Mania Takes Hold Easy credit and low volatility in financial markets made things too easy for both homebuyers and high-yield investors. Investors Rush for Yield and Ignore Risks In some respects, the current crisis was a direct result of an era of placid financial markets, low interest rates and easy credit. Historically low interest rates made it easier for homebuyers to buy bigger houses, encouraging a massive housing boom in the United States. But the same low interest rates left investors desperate to pump up returns on their low-yielding bond investments. As an answer, many of them turned to those credit markets where yields were higher but so were risks. Demand for high-yield investments was so great that it pushed up prices and lowered the yield difference or spread between bonds with good and bad credit ratings. These credit spreads soon hit new lows, and in the rush to find yield, investors ignored the fundamental tenet of credit investing that the riskier the bond, the more yield it should offer investors as compensation. Questionable Mortgage Loans The trouble started in the subprime market, the place of last resort for homebuyers with questionable credit. As the mortgage market took off, mortgage lenders began competing intensely for deals, lowering their underwriting standards in the process. Lenders approved some homebuyers for adjustable-rate mortgages based only on their ability to pay the low introductory interest rate. In other cases, borrowers didn t even need to show tax returns or pay stubs to get loans. As a result, hundreds of thousands of people with questionable credit records were able to get mortgages for houses they couldn t really afford. Credit spreads hit new lows before spiking up in July. High-Yield Bond Spread (Basis Points) Some homebuyers obtained adjustable-rate mortgages based only on their ability to pay low introductory rates. 100 Jul 04 Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Historical analysis does not guarantee future results. Source: Lehman Brothers and AllianceBernstein

5 CDOs Fan the Flame Mortgage lenders were able to continue lending to borrowers with questionable credit histories because they could repackage and resell the loans through complicated securities called collateralized debt obligations (CDOs). CDOs are packaged pools of mortgages contractually organized into highly-structured securities divided into different classes, also known as tranches. The contract specifies, among other things, the order in which the different tranches feel the effect of defaults in the underlying mortgages. CDOs repackage mortgage loans into tranches that offered higher yields and greater risk. Underlying Assets Security 1 Security 2 Security 3 Security 4 Security 5 Security 125 Average Credit Rating BBB+ The CDO contract converts assests into different classes, or tranches, each with its own credit rating. Typical CDO Tranches Super Senior AAA Rated AA Rated A Rated BBB Rated Equity Tranche Losses are assigned to the lowest-quality tranches first. Each tranche has its own credit rating. The Super Senior and AAA rated tranches, which represent the lion s share of the investment, are the highest quality the last to feel the effect of any losses. They also have the lowest yield, appealing mainly to investors who aren t looking for a lot of risk. Yield-Hungry Investors Line Up Lower-rated CDO tranches (also known as equity tranches) are the first to suffer if homebuyers default on their mortgages. To compensate investors for this risk, they offer the highest yields, and this generally attracts hedge funds and other investors with the highest risk appetite. CDOs allowed the subprime market to grow quickly because there was always a ready pool of aggressive investors eager to take on credit risk in return for high yields. Their thirst for lower-rated CDO tranches and for risk in general appeared to be unquenchable. Many hedge funds, in fact, borrowed in order to buy even more CDOs, pumping up their yield and risk. Source: AllianceBernstein CDOs repackage mortgage loans into tranches, some of which offer higher yields and greater risk.

6 Credit Questions: Subprime Woes Redefine the Fixed-Income Markets Reality Sets In In the Form of Delinquencies The subprime market helped to fuel the mortgage boom for some time until it was eventually forced to face reality. Paying the Price The subprime market did its part to sustain the housing sector boom in the United States. It made mortgages available to many people with weaker credit, who ordinarily might have found home ownership out of their reach. But that access had a price in the form of lower credit standards, and the bill would eventually come due. In early 2007, many of the low introductory mortgage rates that made so many loans so affordable began expiring. The interest rates on these mortgages began to reset at higher levels. Weaker borrowers began to struggle to pay for their new homes and began falling behind in their payments. Delinquencies on subprime loans dating from 2006, when some of the riskiest mortgages were issued, have now risen to 22%, more than double the delinquency rate of loans issued in Such a high delinquency rate for recently originated loans is unprecedented. Nobody knows how high the losses in the subprime market will go, but some market estimates exceed $100 Billion. The delinquency rates on recent subprime mortgages are unprecedented. Serious Subprime Mortgage Delinquencies (%) Loans 2005 Loans Loans Loans Months Serious delinquencies of 60 days or more. Source: AllianceBernstein As low introductory mortgage rates gave way to higher market rates, mortgage delinquencies ballooned.

7 Complex Securities Grow Harder to Value Valuing the lower-rated tranches of a CDO is particularly hard in stable markets, but in volatile markets, it s almost impossible. The hedge funds that held the riskiest tranches of CDOs based on these low-quality mortgages were hit the hardest. Hedge funds that want to sell their CDOs are now being forced to do so at fire sale prices, and the dramatic losses in lower-rated CDO tranches sent shock waves through capital markets. The agencies that issued credit ratings on CDOs had to take the extraordinary step of downgrading the ratings of these securities. The losses began taking their toll at an even higher level: recently two large hedge funds from an investment banking firm were wiped out and subsequently liquidated. A Fear Premium Spreads Worries about the subprime market radiated to sectors and geographies in bond markets that had little or nothing to do with U.S. subprime lending. Investors around the world demanded extra yield for taking on riskier investments, even if they weren t high yield. As a result, the yield spread between low-risk and high-risk investments, which had fallen to historically low levels in the past few years, headed in the other direction. The turmoil also buffeted the markets for high-yield bonds and high-yield bank loans. The global investment banks that had been loaning money at low rates to fund leveraged buyouts suddenly were saddled with loans that paid yields below the market rate. And private equity firms trying to privatize companies with cheap bank debt suddenly found that debt impossibly expensive. The chronology of the subprime problem High-Risk Investors Eventually, some homebuyers defaulted on their mortgages, giving high-risk investors losses in Subprime Homebuyers were able to buy mortgages they couldn t afford from Subprime Lenders who were able to package pools of risky mortgages into the equity tranches of CDOs that were eagerly bought by CDOs which caused generalized anxiety in the Bank Loan Market which raised rates for Leveraged Buyouts and caused anxiety in the Stock Market Source: AllianceBernstein

8 6 Credit Questions: Subprime Woes Redefine the Fixed-Income Markets Credit Markets Go Back to Basics The full measure of the fallout from the turbulence in the world s capital markets is still uncertain, but this much is clear: the era of unrealistically easy credit is over and economic fundamentals remain strong. A Return to Rationality? The recent correction in credit prices indicates that we may be entering a more rational environment an environment in which weaker borrowers have to pay significantly more than stronger borrowers. The long-standing principles of the credit market appear to have reasserted themselves. Investors have realized, once again, that there is no free lunch higher yields usually come with a price, in the form of greater risk. One of the measures of that risk, credit spreads, has already adjusted: spreads have moved closer to their long-term averages. And although investors have yet to put the recent challenges into context, things aren t as dire as the headlines make them seem. Market anxiety is still prominent, but it s largely unrelated to economic fundamentals. The CDO market may be dislocated and leveraged buyout transactions may be drying up, but these events have very little to do with the global economic outlook or with corporate fundamentals. Corporations, in fact, are in better shape than at anytime in recent history. Corporate debt levels are close to historic lows, and profits and cash flow are close to historic highs. If the current robust global economic growth continues, we expect this recent bout of volatility to subside before long. Corporate balance sheets remain fundamentally sound. Nonfinancial Corporate Leverage 25x x Historical analysis does not guarantee future results. Through first-quarter 2007 *Pretax Source: Federal Reserve and AllianceBernstein Interest Coverage Ratio* Recent events have very little to do with the global economic outlook or with corporate fundamentals.

9 7 The Broader Context Recent events have led us to reach several conclusions about their impact on the overall U.S. economy, capital markets, financial sector and corporate America. Weaker Housing, but No Recession Likely Even if losses on subprime-mortgage loans reach $100 Billion, we believe it wouldn t be enough to undermine the U.S. economy. The impact will center on the U.S. housing market, weakening it further and pinching consumer spending. Although this development will probably create a strong headwind against U.S. economic growth, it isn t likely to prompt a recession. The Financial System and Corporate Sector We expect to see widespread calls for increased regulation of both the hedge-fund industry and creditrating agencies in the wake of the subprime crisis. Ultimately, we believe the impact on major financial institutions over time will be immaterial. Major banks are substantially stronger than they were a decade ago, making the collapse of a large bank a low-probability event. The liquidity problems that have spread to bond markets aren t likely to derail corporate growth, because fundamentals there remain so solid. Corporations should still be able to finance capital spending, share repurchases and other growth initiatives from their robust cash flows. One of the counterbalances will be robust growth outside the U.S., which is fueling exports and boosting the profitability of U.S. multinational corporations that receive a growing share of their profits from subsidiaries offshore. If the U.S. economic slowdown does become pronounced, it might help to cool inflation and would encourage the Federal Reserve to reduce interest rates otherwise, we expect the Fed to remain on hold.

10 Credit Questions: Subprime Woes Redefine the Fixed-Income Markets A Return to Normalcy and New Opportunities Capital markets seem to have taken a harder look at risk, and at the amount of yield bonds should provide to compensate for those risks. As with any financial market disruption, this one has also presented new opportunities. Reassessing Risk For the past few quarters, we ve noted that volatility in the world s capital markets and credit spreads were unusually low and bound to increase. Low volatility bred complacency, and we felt that a return to normal levels was long overdue. Clearly, the market has taken a more discerning look at risk. When credit spreads were low, our fixed-income teams kept the risk of our portfolios low, believing that investors weren t being paid enough to take on the substantial risks associated with high-yield investments. But things have changed. Investors are now being paid appropriately for these risks, and the market disruptions have actually created opportunities. In our fixed-income portfolios, we ve modestly increased the amount of risk we take in response. Our bond teams are examining high-yield securities that may be underpriced, and some investment-grade corporate bonds and prime residential mortgage-backed securities look particularly attractive. Reexamining the Role of Bonds Where does this leave investors? Which adjustments do they need to make in their bond portfolios? We suggest that investors take this opportunity to reexamine the role bonds play in their portfolios. Over the long term, bonds act as a stabilizing counterweight to a portfolio s stock investments, which are usually more volatile. This doesn t mean that bonds don t have risks of their own. In a truly balanced portfolio, investors shouldn t need to make any adjustments in response to recent events. But the summer of 2007 should serve as a reminder that volatility never leaves capital markets. Don t Get Caught Up in Sensationalism In a time of uncertainty, information can have both positive and negative implications: it s good to stay on top of what s happening in financial markets, but investors shouldn t let sudden swings up or down derail them from a disciplined, well-planned investment strategy.

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