Monthly Global Cash Credit Update

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Georgia Newton
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1 Monthly Global Cash Credit Update As of September 28, 2012 GLOBAL CASH CREDIT RESEARCH SUMMARY In recognition of sustained improvements of credit fundamentals in key sectors of the Cash investment universe, the Global Cash Credit Research team moved its approved list positioning from very conservative to conservative. This resulted in the extension of risk for specific high-quality issuers as well as the addition of several new names in certain stable sectors. This change was made as a result of: Improved balance sheets in the US financial sector. While we expect this sector to be revenue-challenged due to the low interest rate environment, credit and capital concerns have largely abated. Progress in Europe. We remain concerned about political and execution risks in Europe; however, is appears that the market has generally accepted the recent regulatory/central bank proposals and that incremental progress is being made towards market repair. Note that despite these positives, the Global Cash Credit Research team remains very conservatively positioned in this specific sector. Continued good performance in the ABS sectors. As discussed below, credit performance is generally strong across the ABS sectors covered by the Global Cash Credit Research team and new issuance levels reflect good demand for this asset class. Improving economic conditions in the US. While economic conditions remain muted in the US, improvements in consumer confidence, encouraging commentary from the Federal Reserve s latest Beige Book and positive though per SSgA s economist team, suspicious on closer inspection. unemployment insurance claims data, are all indicative of improving fundamentals. Challenges in the cash markets remain significant primarily related to the potential weak execution of central bank proposals in Europe, the impact of the Fiscal Cliff in the US and the effect of a slower Chinese economy on the global economies and any additional risk increases by the Global Cash Credit Research team will likely result from evidence that these concerns are abating as well as higher levels of global economic growth. FINANCIAL INSTITUTIONS EUROPE The devil is in the details and Euro optimism waned in September as the actual specifics of past support pledges emerged. As leaders examined the hard costs of past promises; many caveats were added to prior slogans of we will do whatever it takes (Draghi 09/06/12) and the commitment to break the vicious circle between banks and sovereigns (Eurogroup Statement 07/09/12). Until robust economic growth returns to Europe, we expect negotiating and politicking to continue that will prolong sovereign turmoil. The ECB revealed its newest tool, Outright Monetary Transactions (OMT), on 09/06/12. The ECB will focus on buying short-term (one to three year maturity) sovereign bonds in an unlimited size to maintain stability. This tool will only be used if the targeted country consents to an EFSF/ ESM austerity program (which Spain has not, as of this writing). Failure of a country to strictly follow the program will result in OMT beginning terminated; a potentially very negative market signal were it to occur. Germany s Constitutional Court rejected motions to block ESM ratification this month; removing the final obstacle to creation of this fund. A single supervisory mechanism (SSM) for European banks is a perquisite for allowing the ESM to directly recapitalize banks. That initiative also took a step forward in September with the European Commission publishing its SSM proposal for ECB supervision of banks. It is to be phased-in at the beginning of 2013 and has the ECB supervising all banks by the end of the year (in conjunction with existing national authorities). However, one step forward, two steps back appears to be the rule as Germany subsequently voiced objections to the ESM supporting the periphery s banks. At the end of the month, Germany, the Netherlands, and Finland issued a joint press release stating the ESM can take direct responsibility of problems that occur under the new supervision, but legacy assets should be under the responsibility of national authorities, recanting the previous pledge to break the sovereign-bank feedback loop and reducing any chance Spain has of shifting the costs of its bank bailout onto its euro area neighbors.

2 NORTH AMERICA September marked the 4th consecutive month of spread tightening across US financials. This was driven by a lack of negative headlines, the ECB s introduction of outright monetary transactions (OMT), and the Fed s latest announcement of quantitative easing (QE3). The Fed s launch of QE3 was a massive policy initiative and could be a positive for US banks. With a primary goal of reducing unemployment, the Fed extended its operation twist program in September and pledged to purchase $40 billion of US treasuries and agency MBS on a monthly basis without a specified end date. Some economists suggest that the Fed s balance sheet actions should provide a boost to the economy by bolstering stock market values, reducing mortgage rates, raising home prices, and lowering corporate borrowing costs. For banks, QE3 increases the demand for treasuries/ agencies and results in higher unrealized gains on investment securities. This bolsters Basel 3 tier 1 common capital. In our view, should lower rates result in increased loan demand for businesses and household it may begin to match the willingness of banks to lend, which remains elevated and has continued to improve, according to the Fed s Senior Home Loan Officers Survey. Housing market indicators pointed to renewed signs of optimism and recovery in September, as measured by homebuilder sentiment (which could lead to growth in residential investment moving forward), existing home sales (highest since 2010 homebuyer tax credit), and home prices. Third quarter earnings results will be released in October. Performance in capital markets should be decent but not stellar. Indeed, underlying trading volumes and asset levels increased in September following a seasonally slow month in August. Still, third quarter global M&A volumes fell to the worst level since 2009 given jitters about global economic health and uncertainty in the US. In terms of a key earnings catalyst this quarter, US. banks are benefiting from large gain-on-sale margins on mortgages that are sold as MBS. Given elevated refinancing volume, this will continue to help results amidst a difficult revenue environment. On credit, bank balance sheets have improved, which is positive. Still, US bank profitability metrics are challenged amidst various cyclical/structural factors. For example, net interest income has been hampered by low rates and slow loan growth. The banks are actively trying to replace fee revenue lost from new regulations such as the Durbin Amendment, the CARD Act, and Reg E. Capital markets revenues are much weaker than in the mid-to-late 2000 s, driven in part by significantly reduced leverage. Expense pressures are elevated due to environmental costs pertaining to credit quality, litigation, and new regulations. These pressures should remain a challenge for banks in the medium-term, offset by positive to stable developments on balance sheets. The FDIC hosted a meeting with institutional investors during September to discuss orderly liquidation authority (OLA). While there are a number of unknowns about bank resolution post Dodd-Frank, a key takeaway is that OLA is more detrimental to holding company creditors compared to creditors at the operating company (i.e. bank-level). Under OLA, the holding company capital structure would be restructured to impose losses upon equity, preferred, subordinated and senior holding company creditors based upon seniority. Meanwhile, there are no mechanisms to impose losses on bank-level creditors, including senior and subordinated debt. The FDIC s Transaction Account Guarantee (TAG) program has been in effect since 2008 and provides unlimited coverage for $1.3 trillion in non-interest bearing transaction accounts in the US. These are typically checking and payroll accounts for corporations and municipalities as well as large personal accounts. At year-end, TAG is scheduled to expire. Should the program not be extended, it could result in deposits leaving the banking system, potentially impacting some of the larger banks. This remains an issue to watch over in the final months of 2012 and has garnered additional press in recent weeks. In Canada, financial conditions remain favorable despite an incremental slowdown in the housing market and uncertainty surrounding the global economy. Recent bank earnings were satisfactory although sustainability of markets-related revenues remains a key question. Loan growth is beginning to slow but asset quality remains pristine. New mortgage rules are starting to have an impact on the housing market and bear monitoring. Subpar US growth should weight further on Canadian exports and business investment moving forward. Note that 76% of Canadian exports are destined for the US.

3 AUSTRALIA System credit growth in Australia slowed with August 2012 statistics showing renewed weakness across the board in both housing and credit growth. Overall, year-over-year credit growth of 4.5% is the slowest in Australia in nearly 35 years. Still, home prices rebounded again in September and rose by 1.4% month-to-month. Trends over the past three months have alleviated concerns of a significant decline in home prices. The RBA cut rates by 0.25% in early October to 3.25% citing an uncertain global economy and the potential for the resource investment peak to occur sometime over the next year. This cut is an attempt to bolster other parts of the Australian economy including small businesses and residential construction amidst a bleaker outlook in China. Of note, Chinese growth has been well-below the torrid pace of past years and recent indicators are adding to the uncertainty. Trends in China are tremendously important to monitor for Australia given the country s heightened export dependency to the region. While conditions in the domestic economy have been better, declines in the country s terms of trade position is somewhat disconcerting, having fallen by around 10% from its peak last year due to lower commodity prices. In the immediate term, the biggest risk to the domestic economy is a material fall in commodity prices that translates into a difficult end to the mining boom. Indeed, Australia s resource-related projects are boosting capital expenditures and employment in the country. To be sure, while cancellation or deferral of large projects would draw headlines, it appears that the main questions moving forward have to do with uncommitted projects as opposed to sanctioned ( locked-in ) projects that are underway. While mining investment should keep the economy growing at a healthy pace, non-mining sectors of the economy still look weak and a high Australian dollar is pressuring exporters. Bank earnings in October should point to slowing loan growth. Given the dependency on net interest income, particular attention will be paid to the net interest margin and the impact of recent RBA cuts. SECTOR REVIEWS ASSET-BACKED SECURITIES (ABS) US The US ABS market was, once again, very active in September. New issuance totaled $16.6 billion priced during September. Year-to-date supply is $148 billion, advancing 65% over the comparable 2011 period. The issuance pace should remain brisk in October and November assuming no macroeconomic or political disruptions to the financial markets. At $73 billion, auto ABS accounts for 51% of total supply. Auto and credit card ABS are the major drivers of the year-over-year increase in issuance for US ABS. More credit card issuers (US banks) are tapping the credit card ABS market in order to demonstrate their ability to diversify funding. Year-to-date supply registers almost $32 billion, which is the most since 2009, when annual supply topped $46 billion. Recent new issue maturities range from 3 10 years, demonstrating the market s versatility and depth. For September, 42.6% of new issue ABS had original maturities of two years or less, down from 47.0% in April. Increased issuance from longer average-life credit cards, student loans, and floorplans has contributed to this modest shift. This measure was just 20% in 2007, but we do not expect the maturity schedule to return to that mix anytime soon given continued investor appetite for high quality, short duration securities. During 2012, US vehicle sales have averaged 14.2 million units compared to 12.5 million in 2011, a 14% faster pace. Based on this trend, we expect a continued steady flow of new issue auto ABS, which facilitates US vehicle sales. September vehicle sales registered at million units annualized, slightly above market expectations, and a 3% month-over-month gain. Despite the significant September supply of new issues, US ABS spreads remained relatively flat and close to all-time record lows, having benefitted from material tightening over the last 6 months. Traditional, vanilla ABS asset classes, as well as more esoteric asset classes, have benefitted from the market environment. The price discovery afforded by new deals indicates a market on firm footing. Strong demand and tighter spreads are drawing more issuance to the securitization market improving transparency and liquidity.

4 ASSET-BACKED SECURITIES (ABS) NON-US August captured the traditional summer lull for the European ABS market with little primary issuance and continued demand within the secondary market for high quality ABS. September saw life return to the primary market. The majority of the transactions were from the UK or the Netherlands. Of more interest were the asset classes, which included among others three deals from the UK non-conforming sector and two CMBS deals. Issuance from the prime Dutch RMBS sector remains strong with a further three transactions. A number of the new issuance deals were privately placed, which continues the general trend for Total issuance year-to-date for European ABS amounts to 188 billion, with only 55 billion placed with investors. Publicly placed paper has come almost entirely from the UK and the Netherlands with a small number of mostly French and German Auto ABS deals. Italy is the largest contributor to total volumes with 47 billion, almost all retained. Although year-to-date European ABS issuance has surpassed most market estimates from the beginning of the year, we expect markedly less issuance for the rest of 2012 and With UK prime RMBS dominating market issuance to date, we do not expect the current run rate to hold as we many UK lenders are expected to opt for the Funding for Lending Scheme (FLS) than utilizing the securitization market. The low-cost funding for eligible banks offered through the FLS should offer little incentive for banks to tap the ABS market during However, we do expect continued issuance, albeit at reduced volumes, from large UK banks who want to keep ABS investors engaged through the duration of the FLS window, so that the market remains open and engaged when the scheme expires. ABS continues to offer these banks relatively low cost funding for the respective mortgage businesses. The European ABS secondary market continues to be supported by technical factors with continued demand from investors on the back of on-going improvement in general sentiment. According to Markit, spread levels for senior bonds in sectors such as UK RMBS, Dutch RMBS and Auto ABS have returned to the levels seen in September Tender offers in the European ABS market are still being seen. The early part of the year was dominated by offers from Spanish and Portuguese issuers as they sought to meet the summer EBA stress tests. With this deadline having been passed, recent ABS tenders have been seen from Italy and Ireland. A variation on the tender theme was seen from Banco Santander Totta, where the offer was to exchange RMBS bonds into a covered bond. CORPORATE / INDUSTRIAL GLOBAL Q3 global corporate bond issuance of $949 billion brings the total for the year to $2.9 trillion, the second fastest pace on record, according to data compiled by Bloomberg. Expanded stimulus efforts by central banks from the Federal Reserve to the Bank of Japan are spurring investors to reach for riskier assets as interest rates in the US stands at almost zero percent for the fourth year. This is fueling the biggest gains in bonds since 2009 from the highest-rated to the neediest corporate borrowers. Global bond issuance is being fed by an 80% increase in US sales this quarter from a year earlier as borrowers tap demand for dollar-denominated assets, offering $354 billion of the debt during the period. Companies offered $445 billion of paper in Europe, a gain of 37%. About 71% of proceeds from high-grade issuers of dollar-denominated debt in the third quarter went toward refinancing outstanding obligations, according to Moody s Capital Markets Group. That s up from 63% in the second quarter and compares with a quarterly average of 75% since the first three months of Bond spreads worldwide declined 22 basis points in September to 243 basis points, about the narrowest level since August 2011, Bank of America Merrill Lynch index data show. The measure has averaged about 200 basis points since From a credit perspective, robust corporate debt issuance and spread tightening in the investment grade space are, at least partially, supported by the strength of corporate balance sheets (particularly in the US), which generally continue to improve on a fundamental basis. ASSET-BACKED COMMERCIAL PAPER (ABCP) GLOBAL US ABCP notional balances and yields have remained relatively stagnant over the past few months. US yield levels continue to trade in basis points for one-month maturity and basis points in three-month maturities. European yield levels remain near recent lows following the ECB s decision to cut the deposit facility rate to zero percent. European levels declined 5 10 basis points in one to three

5 month maturities since that announcement. Current levels for one-month maturity ranges 5 30 basis points and for threemonth maturities at basis points. Market participants are speculating that the ECB may contemplate cutting the deposit facility rate further potentially, to negative levels if economic conditions within the Eurozone don t improve in the coming months. Global ABCP issuers continue to see liquidity conditions improve in the one-week to one-month maturities. Several highly-rated bank sponsored issuers are able to issue longer (greater than 3 months) as investors seek opportunities to pick-up yield out the curve. We expect to see a pick-up in three-month plus paper in October as issuers look to fill their funding needs over the year-end. SSgA Global Entities Australia: State Street Global Advisors, Australia, Limited (ABN ) is the holder of an Australian Financial Services Licence (AFSL Number ). Registered office: Level 17, 420 George Street, Sydney, NSW 2000, Australia Telephone: Facsimile: Belgium: State Street Global Advisors Belgium, Office Park Nysdam, 92 Avenue Reine Astrid, B-1310 La Hulpe, Belgium. Telephone: Facsimile: Belgium is a branch of State Street Global Advisors Limited. Canada: State Street Global Advisors, Ltd., 770 Sherbrooke Street West Suite 1200, Montreal, Quebec H3A 1G1 Canada and 30 Adelaide Street East, Suite 500, Toronto, Ontario, M5C 3G6 Canada. Dubai: State Street Bank and Trust Company (Representative Office), Suite 404 4th Floor, Building 4, Emaar Square, Dubai, United Arab Emirates. Telephone: +971 (0) Facsimile: +971 (0) France: State Street Global Advisors France. Authorised and regulated by the Autorité des Marchés Financiers. Registered with the Register of Commerce and Companies of Nanterre under the number Registered office: Immeuble Défense Plaza, rue Delarivière-Lefoullon, Paris La Défense Cedex, France. Telephone: (+33) Facsimile: (+33) Germany: State Street Global Advisors GmbH, Brienner Strasse 59, D Munich. Telephone +49 (0) Facsimile +49 (0) Hong Kong: State Street Global Advisors Asia Limited, 68/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong Telephone: Facsimile: Japan: State Street Global Advisors, Japan, Akasaka, Minato-ku, Tokyo Telephone Financial Instruments Business Operator, Kanto Local Financial Bureau (Kinsho #345). Japan Securities Investment Advisers Association, Investment Trust Association, Japan Securities Dealers Association. Ireland: State Street Global Advisors Ireland Limited is regulated by the Central Bank of Ireland. Incorporated and registered in Ireland at Two Park Place, Upper Hatch Street, Dublin 2. Registered number Member of the Irish Association of Investment Managers. Italy: State Street Global Advisors Ltd., Sede Secondaria di Milano - Via dei Bossi, Milan, Italy. Telephone: Facsimile: Netherlands: State Street Global Advisors Netherlands, Adam Smith Building, Thomas Malthusstraat 1-3, 1066 JR Amsterdam, Netherlands. Telephone: Facsimile , SSgA Netherlands is a branch of State Street Global Advisors Limited. Singapore: State Street Global Advisors Singapore Limited, 168, Robinson Road, #33-01 Capital Tower, Singapore (Company Reg. No: D), Telephone: Facsimile: Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-8027 Zurich. Telephone +41 (0) Facsimile +41 (0) United Kingdom: State Street Global Advisors Limited. Authorised and regulated by the Financial Services Authority. Registered in England. Registered No VAT No Registered office: 20 Churchill Place, Canary Wharf, London, E14 5HJ. Telephone: Facsimile: United States: State Street Global Advisors, One Lincoln Street, Boston, MA Web: The views expressed in this material are the views of SSgA Global Cash through the period ended September 30, 2012 are subject to change based on market and other conditions. The information provideddoes not constitute investment advice and it should not be relied on as such. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Past performance is not a guarantee of future results. Investments in asset backed and mortgage backed securities are subject to prepayment risk which can limit the potential for gain during a declining interest rate environment and increases the potential for loss in a rising interest rate environment. Bond funds contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; issuer credit risk; liquidity risk; and inflation risk. SSgA generally delegates commodities management for separately managed accounts to SSgA FM, a wholly owned subsidiary of State Street and an affiliate of SSgA. SSgA FM is registered as a commodity trading advisor ( CTA ) with the Commodity Futures Trading Commission and National Futures Association. This communication is not specifically directed to investors of separately managed accounts (SMA) utilizing futures, options on futures or swaps. SSgA FM CTA clients should contact SSgA Relationship Management for important CTA materials. State Street Global Advisors is the investment management business of State Street Corporation (NYSE: STT), one of the world s leading providers of financial services to institutional investors STATE STREET CORPORATION ID1737-GCB Exp. Date: 10/31/2013

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