Ubs the Debt Crisis

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Wealth Management Research

20 April 2011

The debt crisis
Consequences of a Greek debt restructuring
• We believe that Greece may need to restructure its debt by 2012,
but we can imagine that political dynamics may already trigger such an event as early as this summer.
Thomas Wacker, CFA, analyst, UBS AG [email protected] Claudia Sigl, analyst, UBS AG [email protected]

Related publications

• Portugal requests funding support, 7 April 2011 • Ireland, Portugal, Spain: Bond view
reconsidered, 25 March 2011

• We think that the ultimate recovery values of Greek government
bonds may be around 40% but highlight that bonds may drop to levels around 25% following the announcement of a restructuring decision. Therefore, we maintain our Sell recommendation as we think bonds can lose much more from current levels.

• Sovereigns in the age of austerity, 25 January
2011

• The Eurozone at the tipping point, 5 January
2011

• A restructuring would trigger renewed pressure on other weaker
countries and the still fragile European banking system. We discuss the most exposed European banks in this note and try to identify possible further contagion effects. Since we first issued a Sell recommendation on Greek government bonds in March 2010, we repeatedly emphasized our view that Greece's debt situation is unsustainable and a debt restructuring can be deferred, but most likely not avoided by funding support from the Eurozone and the IMF. Our latest fundamental review on Greece can be found in "Sovereign debt in the age of austerity," of 18 January 2011, in which we provided a plausibility check and showed how a debt haircut for Greece may appear. Building on this analysis, we show possible further losses for Greek bonds based on current market valuations and identify possible consequences, including capital needs of banks most exposed to a Greek restructuring. We believe that there is further downside potential for holders of Greek government bonds and affirm our Sell recommendation.

• Research Focus: Eurozone: Lost in Transition, 16
February 2011

• Lessons in sovereign default, 3 January 2011
UBS WMR

Fig.1: CDS premiums for peripheral Europe Default protection premium in basis points
1'400 1'200 1'000 800 600 400 200 0
01/10 04/10 07/10 10/10 01/11 04/11

Greece

Portugal

Ireland

Spain

Source: Bloomberg, as of 20 April 2011

This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 8. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

The debt crisis

Ultimately, Greece does not decide to default Normally, countries default on their debt as soon as they run out of liquidity in the respective payment currencies and creditors are unwilling to finance new debt. The Eurozone and the IMF are currently the only creditors willing to provide Greece, Ireland and Portugal with affordable longer-term funding, thereby preventing a default. However, this support can only buy time for countries able to achieve consolidation and will not prevent a debt restructuring if a country's debt situation is already unsustainable, as we consider is the case with Greece. We have held this view since early 2010, and recent comments from IMF and German officials confirm that this scenario is an emerging reality. In fact, these are the parties most likely deciding on a Greek restructuring, as ceasing their funding support for Greece would force the country to default on its bonds and ask its creditors for a restructuring. This is the only option for defaulted sovereigns, as liquidation, which is common for corporate borrowers, is impossible. From an IMF perspective, countries with unsustainable debt dynamics should not receive any further loan installments. For Germany and its major EMU peers, however, the situation is more complex. Supporting Greece is not only an act of political solidarity within the Eurozone, but also prevents realizing a loss on existing loan commitments and protects the still fragile European banking system from another major hit. However, the direct exposure to Greece is rising with every support loan installment and the haircut that is necessary increases with the level of debt. Our base case regarding possible timing of a debt restructuring decision for Greece foresees the first half of 2012. This would grant the European banking sector and the ECB time to prepare for the event, and other weak peripheral countries would gain time to demonstrate that their debt situation is more sustainable. However, political dynamics are impossible to forecast and investors should be aware that this event may even occur as soon as this summer if major parties involved, like Germany and France, would change their mind on this. We believe that a 2011 restructuring decision would cause material market disruptions and contagion may affect also Spain, Italy and Belgium again, which we expect to decouple from these concerns in our base case scenario. Negotiating a debt restructuring Once a borrower ceases payments on debt and is officially deemed "defaulted," a restructuring deal must be negotiated with creditors. No government can decide unilaterally on a debt haircut, and in the case of Greece, the IMF, the ECB and the Eurozone countries would be important parties, but their current share of outstanding debt is too small for them to dictate a restructuring deal. However, their share may by large enough by 2012 to steer the debate. While creditors try to recover as much as possible of their investment, a defaulted country needs to lower its debt burden to sustainable levels, considering its likely recessionary economic environment and lower government revenues in the years following a default. The process of validating all claims against the borrower and negotiating a restructuring can take several years, during which a country is cut off from most funding sources.

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Forms of restructuring There are essentially three instruments that can be used in a restructuring: • Reducing the nominal value of existing debt, which is commonly referred to as a haircut, is the most straightforward and painful way to lower the debt burden • Coupons are not paid while a country is in default. Permanently lowering the interest burden is often an element of restructurings to make existing debt affordable. However, once this debt needs to be refinanced again, interest costs may increase rapidly. • Therefore, this element is often combined with prolonging debt maturities to gain sufficient time for consolidation. From a bondholder perspective, all three elements lead to lower present values of cash flows. Recovery value – how we get there For Greece, S&P estimates a possible recovery value of 30%-50% and our plausibility check published in our 18 January report shows that recovery values higher than 40% would most likely leave Greece with a too high debt burden to consolidate successfully. Considering the country's debt capacity and the special political situation in Europe, we think a Greek restructuring could look like this: • A 25%-30% straight haircut on the nominal value of loans and bonds. • An exchange of existing bonds into new bonds with coupons of no more than 2%-3% and maturities being termed-out by at least 10 years from the current maturity dates. We think exchanging all existing bonds into one uniform security makes little sense as refinancing this bulk redemption may again pose a risk in the future. In order to achieve similar loss rates for all borrowers, Greece may suggest different exchange ratios for existing bonds, which in fact applies different nominal value haircuts, and offer new securities with different coupons and maturities to achieve fair burden sharing for all creditors. To verify possible recovery values for existing bonds, we assumed a 25% haircut, new coupons of 2% and maturities being termed-out by 10 years. We discounted the new cash flows using our forecasted Bund yield curve in 12 months plus a new credit spread of 350 to 400 basis points, which we think would be a minimum risk premium for a country emerging from a debt restructuring. We think Greece would not achieve an investment-grade rating right away as agencies would want to see evidence of stabilization. Distressed trading levels and inverted yield curve The Greek bond yield curve is currently inverted. Higher yields for shortterm bonds reflect the view that these are trading at higher cash prices and have more to lose if there would be a uniform haircut. However, in contrast to liquidation payments, a debt exchange that tries to put a similar burden on all bondholders may lead to higher recovery values for short-term bonds. Having said that, we think it is not prudent to speculate on a highly uncertain outcome of a debt restructuring and loss risk remains largest for high cash price bonds. Fig. 2: Possible further losses on Greek bonds Bond prices for Greek government bonds
110 100 90 80 70 60 50 40 30 20 10 0 201 2014 2017 2020 2023 2026 2029 2032 2035 2038 possible recovery value possible trading level after announcing a restructuring cash prices of Greek bonds

Sources: UBS WMR, Bloomberg as of 20 April 2011.

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Until a restructuring is agreed, bonds would trade at a discount to expected recovery values. Usually, discount rates for distressed debt are at least 20%-25%, as the outcome of a restructuring is highly uncertain and every year of negotiations means a loss of payments. Applying a two-year negotiation period and a 25% discount rate to our rough recovery value estimate of 40%, bonds may trade at around 25% following a restructuring announcement (Fig 2). As a consequence, bonds may decline much more from current market prices. Based on our negative stance on the Greek debt situation, this possible downside risk continues to justify a Sell recommendation, in our view. Immediate consequences of a Greek restructuring The most direct impact would be on holders of Greek government debt, including the ECB, the Eurozone countries and several major banks. The IMF would claim its preferred creditor status and only accept a smaller share of losses, thereby reducing the recovery value for other creditors. The ECB may need to raise further capital as its holdings in Greek bonds are estimated to reach about EUR 50bn, however, we think this would be addressed ahead of a restructuring decision and we think there is no necessary impact of an ECB recapitalization on the euro currency. We think the Greek banks would most likely default along with the sovereign and public entities and companies would also have a high default probability. Private loans would not necessarily need to default as we think Greece would remain part of the Eurozone and payments in euro continue to be possible. However, default rates on private loans would increase strongly, impacting also foreign banks active in private sector lending in Greece. Contagion effects We think other weak countries would suffer from an increased risk perception and see their funding costs rise following a restructuring announcement. Besides the other peripheral countries, Portugal, Ireland, Spain and Italy, we would expect a general widening of risk premiums for borrowers with lower credit quality. We think the most important difference compared to the default of Lehman Brothers in 2008 is that markets were caught by surprise, other banks were in a similarly critical situation and the exposures of investors and business partners to the broker firm were entirely unclear. By supporting Greece for a prolonged period, the Eurozone grants market participants time to prepare for the event. Transparency on exposures will hopefully increase with the 2011 banking stress test that is currently carried out. While the test results may provide a sugar-coated picture of the banking industry's stress resistance, it should at least provide updated figures on banks' credit exposure. We think market disruptions resulting from a default event of this scale should not be underestimated and including all second order effects of a sovereign default, we think there would be a sizeable economic impact on the Eurozone as a whole. Who is holding Greek government bonds? It is quite difficult to identify all parties holding Greek government debt. Since the standby arrangement was set up in May 2010, the IMF has paid out about EUR 14.6bn to Greece, the European countries paid out EUR 29.2bn. Remaining bond market debt stands around EUR 290bn (principal values).

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The ECB is not disclosing its detailed positions acquired under its Securities Markets Programme, but we think from its EUR 77bn of peripheral bonds, Greece may represent up to EUR 50bn, which, considering cash prices at which the ECB may have acquired those, could well represent up to EUR 70bn in nominal value. Using data from the 2010 bank stress testing round, Greek banks were holding almost EUR 58bn; however, we cannot judge how these numbers may have changed in the meantime. Banks current disclosure is very thin and we review the European banks disclosing the largest exposure to Greece in the 2010 stress test below, including updated information where available. Their combined exposure is roughly EUR 30bn and major insurance companies disclosed low individual exposures, which in aggregate cover roughly EUR 15bn. The remainder of almost EUR 120bn is most probably spread over asset managers, pension funds, nonEuropean financial institutions and private investors globally. We think uncertainty about such a large portion of debt could well lead to financial market stress once a restructuring decision would become effective.

Table 1: European Banks' net exposure to Greek sovereign debt and impact of a restructuring in EURbn
Country Postbank Commerzbank BPI Intesa BPCE Soc Gen Credit Agricole Unicredit Erste ING Bank BES LBBW BCP HSH Nordbank Deutsche Bank* BNP Paribas HSBC** Dexia RBS Rabobank Germany Germany Portugal Italy France France France Italy Austria Holland Portugal Germany Portugal Germany Germany France UK Belgium UK Holland Exposure to Greek Sovereign Debt Trading book 0 0 0 207 39 2'400 120 152 8 506 0 87 5 1 0 4'539 800 3'461 854 0 Bank book 1'337 2'900 0 568 1197 500 535 649 748 1'919 0 1'357 713 196 0 479 300 1 1'511 0 Net total 1'337 2'900 501 776 1'197 2'700 655 801 757 2'425 309 1'389 718 196 1'601 5'046 1'100 3'462 2'365 408 Greece exposure Core Tier 1 / core capital ratio 35.55% 19.02% 25.51% 2.97% 3.75% 9.49% 2.10% 2.05% 6.97% 7.87% 4.69% 10.07% 11.70% 4.58% 4.42% 7.84% 0.95% 21.60% 4.10% 1.33% 5.67% 5.69% 7.51% 7.88% 7.98% 8.50% 8.40% 8.58% 9.07% 9.60% 9.62% 10.07% 10.30% 10.33% 10.45% 10.71% 10.53% 11.39% 10.61% 14.02% Core Tier 1 ratio 4.90% 5.28% 6.80% 7.79% 7.86% 8.20% 8.34% 8.52% 8.84% 9.33% 9.46% 9.71% 9.87% 10.16% 10.28% 10.41% 10.49% 10.51% 12.30% 13.96% Core Tier 1 ratio 4.51% 5.07% 6.44% 7.75% 7.81% 8.06% 8.30% 8.48% 8.72% 9.19% 9.37% 9.52% 9.65% 10.07% 10.20% 10.26% 10.47% 10.07% 12.21% 13.93% 40% loss adjusted 60% loss adjusted

Sources: UBS WMR, UBS IB, BNP Paribas, CEBS, Fitch Ratings, company data * including Postbank figures ** quoted in USD

European banks most exposed to Greece Our sample includes 20 banks that had the highest exposures to Greek government bonds according to the 2010 banking stress test, considering both the highest absolute positions and highest positions relative to the bank's equity. The official stress test only considered positions held for trading, which are subject to fair value accounting. However, most positions in peripheral European government bonds are held to maturity, and banks would only need to realize losses on these in case of a default. As we continue to believe that Ireland and Portugal will not default in the next few years, we

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The debt crisis

concentrate on the Greek government bond positions and apply possible loss rates of 40% and 60% to banks' positions. This assumption is derived from our recovery value discussion above. Among the three most affected banks are Postbank, Commerzbank and Dexia Group. Postbank was acquired by Deutsche Bank at the end of 2010. The latter holds 52% of Postbank shares. Postbank will be fully integrated into Deutsche Bank Group but will continue to operate under its own brand. Following the acquisition by the German market leader, Postbank's capital and funding position improved significantly. Currently, the Greek sovereign exposure versus its core capital accounts for roughly 36%. Applying a loss rate of 40% and 60% respectively would hit core capital significantly, reducing the core tier 1 ratio to very low 4.9% and 4.5% respectively. Given the intended integration into Deutsche Bank, Postbank should be able to withstand such a loss scenario without further capital injection needs and funding difficulties. However, Deutsche Bank's Greek sovereign exposures versus its core capital accounts for roughly 4.4% (on a group basis). Given a potential loss rate of 40% and 60% respectively, the core tier 1 capital ratio should remain almost unchanged. Commerzbank's systemic importance for the German banking system was proven by strong government support: the German government has a stake of 25%, which limited the strategic scope, and provided silent participations (EUR 17.2bn) via Financial Market Stabilisation Fund (SoFFin). Recently, Commerzbank announced the intention to reduce silent participations with target volume of EUR 11.0bn until June 2011. In a first step, the bank managed to redeem the majority of the silent participations of SoFFin for a total of EUR 5.7bn. This measure slightly improves the core tier 1 equity of Commerzbank. Currently, the Greek sovereign exposure versus core capital accounts for roughly 19%. Applying a loss rate of 40% and 60% respectively would hit core capital significantly, reducing the core tier 1 ratio to very low 5.3% and 5.1% respectively. Given the intended conversion of the majority of silent participations into core capital and the continued government support, Commerzbank should be able to withstand such a loss scenario without further capital injection needs and funding difficulties. Dexia Group is heavily exposed to peripheral sovereign debt. Our base case scenario builds on a core tier 1 equity of EUR 16bn, which includes the phasing in of deductions according to future Basel 3 regulations. Here, the Greek sovereign exposures versus core capital accounts for roughly 22%. In our base-case scenario as related to a loss rate of 40% and 60% respectively, we forecast that the core tier 1 ratio declines either 90 or 130 bp to 10.1%. Dexia has some flexibility to resume its cash dividend. We think the capital base appears sufficient to withstand our base scenario. Our worst case scenario builds on a core tier 1 equity of EUR 5.6bn, which excludes the phasing in of deductions according to future Basel 3 regulations. Here, the Greek sovereign exposure versus core capital accounts for more than 62%. Applying a loss rate of 40% and 60% respectively would hit core capital significantly, reducing the core tier 1 ratio to an unsustainable 3% and 2.5% respectively. In our view, the majority owners – the French and Belgian governments – would provide state aid. Capital injections and liquidity facilities provided by the

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The debt crisis

respective governments should help Dexia Group to withstand our worstcase scenario. Nevertheless, potential losses from the remaining peripheral sovereign debt portfolio should be taken into account. Consequently, the capitalization and funding situation should become even more problematic. Therefore, we recommend avoiding bonds of Dexia. We view bonds of Dexia Group as unattractive compared to other bonds of the same rating category; they should therefore not be considered for new investments, in our view. As long as WMR has not issued a 'Sell' recommendation, existing positions may be held. Banks with exposure to other assets in Greece would possibly incur much larger losses. We identify the following banks with sizeable lending exposure to non-sovereign borrowers: • Credit Agricole with its 91% stake in Greek Emporiki Bank. Even if the total loan book of Emporiki (EUR 21.3 bn) accounts only for a 2.4% share of Credit Agricole's gross loans, potential support for the subsidiary may add to its overall burden and weigh on the bank's credit profile. • In addition to the problems that Portuguese banks are facing in their home country, most Portuguese banks are significantly exposed to other assets in Greece via their subsidiaries. To conclude, we think a smaller part of the total losses will result from the above mentioned sovereign debt portfolios. However, the major stresses and strains should stem from the overall capital market uncertainties which affect funding costs and limit access to fresh capital. Furthermore, a significant part of the potential losses should come from undisclosed Greek corporate lending exposures.

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Appendix
If you require further information on the instruments or issuers mentioned in this publication, or you require general information on UBS Wealth Management Research including research policies and statistics regarding past recommendations, please contact either your Client Advisor or the mailbox [email protected] giving your country of residence. Disclosures (20 April 2011) Commerzbank 2, 4, 5, 6, 7, 8, 9, 11, 12; Crédit Agricole 4, 8, 9, 12; Deutsche Bank 1, 3, 4, 6, 7, 8, 9, 12; Deutsche Postbank 4, 9, 10, 12; Dexia 1, 4, 9, 11, Portugal 1. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and investment banking services are being, or have been, provided. 2. UBS Limited acts as broker to this company. 3. UBS AG, its affiliates or subsidiaries has issued a warrant the value of which is based on one or more of the financial instruments of this company. 4. UBS AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services from this company/entity within the next three months. 5. UBS Limited is acting as manager/co-manager, underwriter, placement or sales agent in regard to an offering of securities of this company/entity or one of its affiliates. 6. This company/entity is, or within the past 12 months has been, a client of UBS Financial Services Inc, and non-investment banking securities-related services are being, or have been, provided. 7. Within the past 12 months, UBS Financial Services Inc has received compensation for products and services other than investment banking services from this company. 8. UBS Securities LLC makes a market in the securities and/or ADRs of this company. 9. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking services from this company/entity. 10. UBS AG, its affiliates or subsidiaries beneficially held more than 5% of the total issued share capital of this company; or for UK and Irish companies, a line of stock of this company; as of the date shown in this disclosure table. 11. UBS AG, its affiliates or subsidiaries held other significant financial interests in this company/entity as of last month's end (or the prior month's end if this report is dated less than 10 working days after the most recent month's end). 12. UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of this company/entity or one of its affiliates within the past 12 months.

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Appendix
Stock selection system: Analysts provide three equity selections (Most Preferred, Neutral View, Least Preferred). Equity preference: Most preferred: Taking into consideration the stock's rating as well as other factors relevant for portfolio management (e.g. risk, diversification), analysts expect the stock to contribute positively to the overall performance of the relevant Equity Preference List (EPL) in the next 12 months, i.e. to outperform versus the thematic benchmark. Neutral view: Analysts expect the stock to neither contribute positively nor negatively to the performance of the relevant EPL, i.e. to perform in line with the thematic benchmark in the next 12 months. Least preferred: Taking into consideration the stock's rating as well as other factors relevant for portfolio management (e.g. risk, diversification), analysts expect the stock to contribute positively to the relevant EPL in the next 12 months, i.e. to underperform versus the thematic benchmark, which results in a positive contribution to the EPL. Suspended Issuing an analyst's research on a company can be restricted due to legal, regulatory, contractual or best business practice obligations, which are normally caused by UBS Investment Bank’s participation in an investment banking transaction involving the company concerned. Equity Selections: An assessment versus a benchmark Equity selections are a relative assessment versus a thematic benchmark. Analysts select a benchmark for every thematic investment context they define, be it a regional, sector or other investment context. These benchmarks are often defined as MSCI Level 1, 2 or 3. In cases where such benchmarks do not appropriately reflect the investment context, we may deem a different benchmark more appropriate. The assigned benchmark is also used to measure the performance of the individual analyst. Stocks can be selected for several Equity Preference Lists (EPLs). In order to keep the various preference lists consistent, a stock can only be selected as a part of either Most Preferred lists or Least Preferred lists. As benchmarks among lists differ, stocks must not necessarily be included on every list they could theoretically be added to. UBS's selection methodology shows private clients how to best invest if they would like to profit from a specific investment theme. Current UBS global rating distribution (as of last month-end) Buy Neutral Sell Suspended Discontinued 51.36% 33.49% 6.57% 1.18% 7.40% (40.09%*) (44.17%*) (22.52%*) (40.00%*) (24.00%*) . . . . . . . . . . . . . . .

*Percentage of companies within this rating for which investment banking services were provided by UBS AG or UBS Securities LLC or its affiliates within the past 12 months.

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Appendix
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Singapore: Please contact UBS AG Singapore branch, an exempt financial adviser under the Singapore Financial Advisers Act (Cap. 110) and a wholesale bank licensed under the Singapore Banking Act (Cap. 19) regulated by the Monetary Authority of Singapore, in respect of any matters arising from, or in connection with, the analysis or report. Spain: This publication is distributed to clients of UBS Bank, S.A. by UBS Bank, S.A., a bank registered with the Bank of Spain. UAE: This research report is not intended to constitute an offer, sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE). The contents of this report have not been and will

Wealth Management Research 20 April 2011

10

The debt crisis

Appendix
Disclaimer
not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities, the Emirates Securities and Commodities Authority, the Dubai Financial Market, the Abu Dhabi Securities market or any other UAE exchange. UK: Approved by UBS AG, authorized and regulated in the UK by the Financial Services Authority. A member of the London Stock Exchange. This publication is distributed to private clients of UBS London in the UK. Where products or services are provided from outside the UK, they will not be covered by the UK regulatory regime or the Financial Services Compensation Scheme. USA: This document is not intended for distribution into the US and / or to US persons. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc., UBS Financial Services Inc. is a subsidiary of UBS AG.Version as per January 2011. © UBS 2011. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

Wealth Management Research 20 April 2011

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