BARCLAYS GLOBAL INVESTORS May 2008

A Review of the 2007-08 Market Turmoil

0
Excess Liquidity…

1
…can be reduced to a trickle

2
Sub-Prime Market Contagion

The first signs

•  Sub-prime loss forecasts hit
equity markets in February ASX 200
Index
•  Two Bear Stearns funds
liquidate assets in June
Rel. Value
Liquidity Crisis Hedge Fund
Index
•  Bank funding costs soar in
August 2007
•  Central banks provide LIBOR – T-Bill
massive liquidity injections Spread

Credit Crisis
•  Northern Rock fails in
September
iTraxx (Aus)
•  Bear Stearns collapses in Spread
March 2008

Source: Bloomberg
3
Timeline of Key Events

Late 2006 US housing market begins to slow

December 2006 Spreads on sub-prime securities begin to widen
8 February 2007 Sub-prime lender New Century Financial Corp presages losses
27 February China’s stock market plunges and global markets follow
2 April New Century files for bankruptcy…others follow
20 June Two Bear Stearns funds begin liquidation of sub-prime assets
19 July Standard & Poor’s begins to slash sub-prime debt ratings
26 July Margins on leveraged loans widen dramatically
31 July Leveraged loan fund Sowood Capital announces losses of 57%
9 August European Central Bank injects close to 100 billion Euros into
interbank lending markets
Source: Reuters, BBC, Bloomberg

4
Timeline of Key Events (cont.)

15 August Basis Capital warns of catastrophic fund losses

16 August Countrywide unable to roll short-term financing and RAMS
share price collapses after it calls on emergency bank funding
17 August Federal Reserve cuts target rate by 50 basis points
31 August The troubled Bear Stearns hedge funds file for bankruptcy
13 September Northern Rock suffers a run and requires emergency Bank of
England funding
18 September Federal Reserve cuts rates a further 50 basis points
24 September Merrill Lynch announced $8.4 billion in write-downs
1 October UBS announces $3.4 billion in write-downs
15 October Citi announces $6.5 billion in write-downs
Source: Reuters, BBC, Bloomberg

5
Timeline of Key Events (cont.)

31 October Federal Reserve cuts target rate by 25 basis points to 4.5%

4 November Citi announces further $10 billion in losses and Chairman and
CEO Charles Prince resigns
15 November Federal Reserve injects almost $50 billion into banking system
19 December Morgan Stanley announces $9.4 billion sub-prime write-down
17 January 2008 Merrill Lynch reveals approximately $16 billion in write-downs
24 January Société Générale announces $7 billion loss due to “rogue trader”
25 February Standard & Poor’s downgrades XL Capital Assurance six
notches from AAA to A-
1 April UBS doubles its write-downs to a total of $37.4 billion
14 March Federal Reserve arranges bail-out for Bear Stearns to avoid
bankruptcy
Source: Reuters, BBC, Bloomberg

6
Bubbles and Liquidity
Fundamentals
•  Market prices generally reflect future expectations:
•  Earnings for equities
•  Central bank cash rates for Treasuries and Swaps
•  Default rates for credit spreads
•  Additional compensation is provided for volatility or lack of liquidity

Technicals
•  Waves of demand can push prices beyond fundamentals and squeeze away
risk premia: this can result in an asset price “bubble”
•  A “rush for the door” can occur suddenly, rapidly deflating the bubble
•  “The market can stay irrational longer than you can stay solvent” (Keynes)

7
The US Sub-Prime Market

End of a Housing Bubble Case-Schiller House Price Index

•  In late 2006, a ten-year run in US 250

house prices came to an end
•  Subprime origination had become a 200

large part of the market and many

150
had low initial mortgage rates
•  Many borrowers relied on selling 100
into a rising market
50
Layers of Leverage
•  Most subprime risk was embedded 0

Jan-87

Jan-89

Jan-91

Jan-93

Jan-07
Jan-05
Jan-95

Jan-97

Jan-99

Jan-01

Jan-03
in asset-backed securities and CDOs
•  Funds, SIVs and banks had further
leveraged these assets, which had Source: Standard & Poor’s

become unsaleable

8
Interest Rate Resets

The Honeymoon is Over Sub-Prime Reset Estimates

•  Concerns began to grow about sub- 25

prime borrowers reaching the end of
their “teaser” rate period 20

•  Estimates of volumes of mortgages

resetting each month began to 15

US $bn
circulate widely
10
•  The figures exacerbated concerns
about growing delinquencies and
5
defaults among sub-prime borrowers
•  The impact on pricing of asset- 0
backed securities was severe Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09

Source: Loan Performance Data

9
Asset-Backed Securities

Pain All the Way to AAA ABX AAA Index (2007 Series 1)

•  The performance of asset-backed 100

securities became dramatically
evident in the “ABX” asset-backed 90
credit default swap indices
•  Credit default swaps have been a 80
more visible indicator of market
pricing than underlying securities 70
•  The AAA tranche index began
moving in percentage points not 60
basis points, leading to focus on
rating agency methodologies
50
•  Recent months have seen a May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08
significant recovery, but the index Source: JP Morgan
remains well below par

10
Leverage and Liquidity
The Multiplier Effect
•  Borrowing to invest creates an attractive multiplier effect in rising markets
•  Cheap financing increases the attractiveness of leverage
•  Leverage also multiplies losses in falling markets, but not all leverage is catastrophic

The Riskiest Leverage: Borrow Short, Invest Long

•  A long-term borrower who can meet interest payments and is not forced to sell their assets
can ride out the storm, waiting for distressed asset prices to recover
•  A short-term borrower may not be so lucky if they are unable to refinance their borrowings
(e.g. RAMS, ABC Learning)
•  For short-term borrowers, if the market thinks you have a problem, then you have a
problem (e.g. Northern Rock and Bear Stearns)
•  Results are similar for a fund facing redemption or for a borrower subject to margin calls
(e.g. Sowood Capital, multi-strategy hedge funds)
•  Even long-term borrowers can be in trouble if they are unable to service their debt

11
Write Downs and Capital Injections

Apr-08 figures in US$bn Writedowns New Capital

UBS 38 Citigroup 30

Citigroup 35 UBS 28
Merill Lynch 32 IKB 13

Morgan Stanley 13 Bank of America 13

Bank of America 9 Merrill Lynch 13
IKB 9 Wachovia 11
Deutsche Bank 8 WaMu 10
Credit Agricole 7 Barclays 9
Others 98 Others 36
Total 248 Total 163
Source: Morgan Stanley, Bloomberg

12
Short-term Bank Borrowing

Liquidity Squeeze 3 month LIBOR – Treasury Spread

•  Concerns about hidden sub- 300

prime exposures meant banks
became reluctant to lend to
one-another
•  Banks depend heavily on 200
short-term wholesale funding

basis points
•  The result is a vicious cycle:
banks respond by curbing
lending where they can 100
•  This effect is evident in the average
blowout in the bank lending
spreads
•  Central banks responded with 0
massive liquidity injections 98 99 00 01 02 03 04 05 06 07
and new funding measures,
such as accepting more forms Source: Bloomberg

of collateral

13
The Impact on Credit Markets

Liquidity Crisis to Credit Crisis Global Asset Swap Margins

•  Short-term bank borrowing costs 200
remained high
Industrials
•  As subprime-related losses were 175
Financials
announced, the market remained 150
convinced that more was to come
•  Concerns mounted about 125

basis points
financial institutions and pricing 100
also affected corporate spreads
75
“No Bank Left Behind” 50
•  Relief rally after Bear Stearns was
25
bailed out by the Fed
•  Although jittery at times, credit 0
derivative markets have shown 1996 1998 2000 2002 2004 2006
increased confidence from April
Source: Bloomberg, Merrill Lynch

14
Impact on Fixed Income Funds

Credit Tilts US Core Plus Manager Performance

•  Active fixed income returns have
largely been driven by overweight 4% 40%
credit positions
3% 30%
•  This was a positive contributor

excess returns (rolling 12 mth)

from 2003, but the credit crunch

realised alpha (rolling 12 mth)

2% 20%
led to a rapid reversal of gains
1% 10%
Liquidity Challenges
•  The worst affected positions have 0% 0%
been the hardest to sell – another

1988
1990

1992
1994

1996
1998

2000
2002

2004
2006
form of liquidity risk -1% -10%
•  Attempts to de-risk or manage
redemptions often involved -2% Managers (LHS) -20%
selling the better-quality assets High Yield Index (RHS)
-3% -30%

Source: eVestment Alliance

15
Why No “De-Coupling” for Australia?

A Strong Economy Was No Protection Australian Asset Swap Margins

•  While Australia’s economy remained strong 150
through 2007, financial markets did not Industrials

escape contagion Financials

basis points
100
•  Australian borrowers, particularly banks, rely
heavily on global capital markets which
50
drove up funding costs

0
1997 1999 2001 2003 2005 2007
Australian iTraxx Index
Source: Bloomberg, Merrill Lynch

200
Spreads Driving By Financing
basis points

150

100 •  Financials are a large component of Australian

credit markets and pushed spreads wider
50
•  Dependence on short-term financing took its
0
toll: a number of firms collapsed or came close
Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

•  Australian credit market experience has

mirrored global markets, unlike 2001-03
Source: Bloomberg

16
A Parallel in US Hedge Funds

A Tenuous Link? Relative Value Hedge Fund Index

(3 month rolling returns)
•  In August 2007, US relative value
funds suffered sudden
6.0%
unexpected losses
•  The link to subprime mortgages 4.0%
was not immediately apparent
2.0%
•  The proximate cause appeared to
margin calls by prime-brokers 0.0%

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07
Dec-03

Dec-04

Dec-05

Dec-06

Dec-07
-2.0%
Another Liquidity Problem
-4.0%
•  Some commentators point to the
rapid growth of relative value -6.0%
funds pursuing similar insights
and holding similar positions -8.0%
•  Perhaps the ultimate cause was a -10.0%
“bubble” in hedge-fund growth
Source: Bloomberg, Hedge Fund Research Inc.

17
Can A Lesson Be Learnt?

No More Sub-Prime CDOs

•  There has been no new issuance of sub-prime backed collateralised debt obligations
and there probably never will be again (at least, not in quite the same form)
•  Even the prime mortgage securitisation market remains effectively closed and may be
for some time
•  Markets may not make exactly the same mistake again, but…

History Repeats
•  Tulipomania in the 1600s
•  South Sea bubble in the 1700s
•  Share market speculation boom in the 1920s
•  The Tech Bubble in the late 1990s, bursting in 2000
•  US Housing bubble in the early 2000s

What Will Be Next?

18
The Aftermath

The Market
•  Lack of liquidity and distressed selling often leads to over-correction of asset bubbles
•  Market risk aversion has increased significantly and risk premia have increased

The Economy
•  The US economy remains extremely weak and the impact on the global economy is unclear
•  Concerns about energy and food prices is keeping a focus on inflation risks

Credit
•  Credit markets have already strengthened significantly
•  Risk premium has returned, but economic risks mean that security selection is crucial

Rates
•  Combating the liquidity crisis has led to some very low rates, exacerbating inflation
concerns
•  The term premium may return, but yield curves remain volatile, creating risk but also
opportunities 19