The 20 Rising Stars of Fixed Income 2008

Alarmingly, serious delinquencies - defined as payments more than 90 days late, foreclosures and bank repossessions for RMBS issued in 2005, 2006 and 2007 were 25.96%, 25.02% and 17.14% of the aggregate pool balances, respectively. Serious delinquencies have increased by approximately 7% for the 2005 vintage, 7% for 2006 and 12% for 2007. These are startling increases. The question is: Are they abating or aggravating? Some Optimism, More Pessimism The securitization markets overall are producing cautious optimism from some and serious alarm from many others. Rather than seeing the beginning of the end, Jeffrey Rosenberg, Bank of America's head of credit strategy research, recently wrote: “Bear Stearns marks the end of the beginning of the credit crunch. Count the April 10 earnings miss from General Electric as the beginning of the next phase, as financial risk bleeds into economic risk and the impact of the credit crunch begins to be registered in the real economy.” From there, Rosenberg’s scenario only gets worse. “The combination of asset writedowns and the 're-intermediation' of financial markets as securitization markets flounder results in severe pressure on leverage and capital ratios of financial institutions,” he wrote. “The resulting substantial withdrawal of credit availability leads…to an oncoming deep household-led recession.” Apart from mortgages and mortgage-backed securities, SIFMA's 2007 report noted that $6.44 trillion worth of corporate and municipal bonds were issued last year, nearly undiminished from the $6.47 trillion of the year before. However, these numbers were somewhat misleading, as 2007's first half was well one its way to a record. The second half of the year, however, saw corporate bond issuance volumes slowing to $2.70 trillion from $3.74 trillion in the first half, while fourth quarter volume was just $1.36 trillion compared to $1.72 trillion in the fourth quarter of 2006. It remains a bit early for any significant statistical evidence of the continued recession of the fixed-income markets, but SIFMA reported that issuance of high-yield corporate bonds fell 90.9% this year through February 2008, compared to the same period the year before. Meantime, between January and February, the issuance of investment-grade corporate bonds dropped to $48.9 billion from $97.4 billion; and to $48.9 billion from $67.3 billion in February 2007. SIFMA's first-quarter survey of its 650-plus members’ economists and analysts yielded a projected decline of about 50% in private-label issuance this year. However, their consensus view was that the second half of 2008 ought to see a recovery of the fixed-income markets. “Their view was that the pickup in the second half will be based on three factors: the success of Federal Reserve policy; MAY 2008 the benefit of stronger global growth, based in particular on the emerging markets; and energy prices,” Davidson said. “That the second half is likely to be stronger than the first half isn't saying much.” SIFMA-member economists also lauded the federal stimulus package, in part because of the tax rebates being extended to taxpayers. More significant, Davidson said, is the Fed's mid-March announcement of its Term Securities Lending Facility. This lending program made as much as $200 billion available to primary dealers, such as major brokerages and banks, for a term of 28 days - the existing program made such loans overnight—in return for various types of collateral. The Road to Recovery? Some of the longer-term optimism stems from the pullback of the fixed-income markets. On the corporate bond side, for instance, the weakness in the economy has produced the expectation of a higher numbers of defaults over the next year. Given these reduced expectations, refinancings of corporate bonds through the first half of the year have been relatively modest. “The broader point is that corporate balance sheets have strengthened over the last few years as a result of some profit growth, and the downturn in the corporate bond market will undoubtedly be a good deal more modest than we've seen in the mortgage arena,” Davidson said. Furthermore, the retrenching of corporate bond underwriting is a healthy sign of a flight to quality, he added. Davidson believes the current credit crunch has taught market participants a series of bitter but valuable lessons that ought to stick. “This is not the first, and probably not the last, bubble,” he said. “Over the last 30 years, you could chronicle a number of bubbles. However, this has been a lesson that will be remembered for the better part of the next decade, so you are not going to see the same mistakes repeated.” Many observers are more pessimistic than that. Mike Dahood, president of Fixed Income Research Company, described his ‘Pollyanna scenario’ as one in which inflation forces Treasury yields higher, meaning existing bonds are priced at a discount while new bond issues are priced at wider spreads - a perfect storm of unhappy convergences. Fed actions so far have amounted to a needed sort of triage, Dahood noted. How long it takes the patient to fully recover is a different question. “Companies will get out of this period,” Dahood said. “But I don't know if it ends in 2008, in 2009 or if it extends until 2010. Clearly, actions by the Fed have been beneficial in improving the underlying economic conditions, but at the cost of making inflation risks much higher.” i FIXED INCOME RISING STARS 7

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