19 July 2010

Economics
Beyond the Cycle
www.sgresearch.com

American Themes
From muni crisis to US sovereign debt crisis?
Stephen Gallagher Chief Americas Economist (1) 212 278 4496
stephen.gallagher@sgcib.com

The 2008-2009 recession has produced a significant crunch in state finances. Last year, budget gaps were plugged with federal stimulus money, but now that the funds are running out, states face renewed pressures. Here, we evaluate the risks for the US economy and financial markets.
Q Municipal defaults likely to rise

Aneta Markowska US Senior Economist (1) 212 278 6653

aneta.markowska@sgcib.com

Martin Rose Research Associate (1) 212 278 7043

martin.rose@sgcib.com

We anticipate a rise in municipal defaults in the coming quarters, which is normal following deep recessions. A state default would be far more serious, but remains unlikely in our view. There has only been one state default in the past 110 years. Arkansas defaulted in 1933 and functioned on federal money for two years.

Q EMU members vs. US states The key similarity is the need for austerity, which is the only sustainable solution to the current budget woes. The main difference is the financial linkages,

which are much weaker in the case of municipal debt. Only 10% of the $2.8 trillion municipal debt market is held by banking institutions, with the vast majority owned by wealthy households. This suggests much smaller risks of financial contagion.
Q What could go wrong risk scenarios

A rise in municipal defaults could spook investors

and trigger a funding crisis for state and local governments. While the Fed can purchase short-term municipal paper as part of open market operations, we believe that the first round of help would come from the federal government. How much help might be needed? We estimate the projected budget gaps plus refinancing needs add up to about $300-$350 bn, or about 2% of GDP. In the event of a federal bailout, we must also consider the risk of secondround contagion effects into the Treasury market. If this risk were to materialize, we believe that the Fed would likely restart quantitative easing. Fed purchases would cap Treasury yields, but the dollar would suffer in this monetization end-game.

How are states closing their budget gaps? FY2010 cuts by program:
9.0 USD bln 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 K-12 Education Higher Education Public Assistance Medicaid Corrections Transporation Other

FY'2010 spending cuts by program

Source: National Governors Association

Macro

Commodities

Forex

Rates

Equity

Credit

Derivatives

Please see important disclaimer and disclosures at the end of the document

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Recent tremors in the municipal debt market

Troubled States
5Y CDS Illinois California New York Michigan New Jersey Nevada Florida 315.0 281.9 248.6 245.8 240.0 210.0 153.8 S&P Rating A+ AAA AAAA AA+ AAA

The 2008-2009 recession has produced a significant crunch in state finances. Last year, budget gaps were plugged with federal stimulus money, but now that the funds are running out, states face renewed pressures. In recent months, several small municipalities have warned against potential default. A rise in municipal defaults is not unusual following recessions, and particularly following the last recession which was very severe both in its depth and its duration. However, these warnings have spooked municipal bond investors. The average municipal CDS spread as measured by the MCDX index have widened out from 120 bps in late April to 250 bps in late
S&P Rating BB+ AAA AA A+

Troubled EMU Members

5Y CDS Greece Portugal Ireland Spain Italy 802.2 289.3 250.9 220.5 176.2

June (although spreads are still below the peak levels of 2008 when the auction rate market shut down, triggering funding problems for many issuers). Spread movement in the cash market has been less pronounced. In price terms, most securities have not moved much and state and local governments have not seen much change in their borrowing costs, albeit municipal yields failed to follow Treasury yields down over the past month. The sharp widening in the CDS market has triggered a lot of concern among investors. In particular, there have been a lot of questions about potential contagion to the broader financial markets, similar to the way the seemingly small Greek problems spilt over to other peripheral sovereigns and ultimately to the banking sector.

Source: Bloomberg; data as of Friday July 16

Municipal spreads show some pressures

400 350 300 250 200 150 100 50 0 -50 -100 02 03 04 05 06 07 08 09 10 bps 300 250

though yields have remained stable

8.0 bps 7.0

Markit CDS Index 5Y (LHS) Muni AAA/A- vs. Treasury (RHS)

200 150 100 50 0 -50 -100

Muni AAA/AMuni Insured Muni BBB+/BBB-

6.0

5.0

4.0

3.0
-150 -200

2.0 00 01 02 03 04 05 06 07 08 09 10

Source: Bloomberg, SG Cross Asset Research

Whats in the $2.8 trillion municipal debt market?

The municipal debt market is very fragmented and represents many different types of issuers including, states, counties, cities, towns, school districts, special districts, utilities, transportation systems, universities and hospitals, often with multiple securities. The bonds can be backed by revenue streams tied to specific projects (65% of the market), or, in the case of general obligation bonds, by the full faith and credit of the issuing governmental body (35% of the market). The average size of a municipal issue is much smaller than in the corporate markets. While the overall size of the corporate market is much larger, at $11 trillion in total vs. $2.8 trillion in

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outstanding municipal securities, the municipal market has about 50,000 issuers vs. 3,000 corporate issuers. Defaults tend to be much lower in the municipal market, for the simple reason that the issuers operate as monopolies in their respective markets and have greater flexibility raising revenue than corporations, either by raising taxes, increasing fees or implementing new user charges. However, municipalities are much more constrained in managing their expenses as they are often burdened by unfunded mandates passed down from the federal and state governments (healthcare, social services).

Why are states in trouble?

States in fiscal peril
Many comparisons have been made between US states and the weaker EMU members with unsustainable debt dynamics. From the debt load perspective, the states are in much better shape. Overall state and local government debt is at just 20% of GDP. Adding it to the federal debt pushes the overall general government debt to roughly 75% of GDP, which is more problematic. However, the bigger of the two problems is federal government which is in much worse shape than the states given its large debt loads and an unsustainable fiscal outlook.
Standalone state debt
40 % of GDP 35

In the context of federal debt

90

State & Local Gov't Debt

80 70 60

% of GDP

Treasury Debt State & Local Gov't Debt

30

25
50

20
40

15
30

10

20 10 0

0 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09
Source: Global Insight, SG Cross Asset Research

52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09

For the states, the key problem is not debt levels, but the recent budget gaps. The last recession was the costliest post-war downturn for the states, both because of its severity and its duration. In the previous recessions, states fiscal problems lasted for several years after the economic trough; this time, problems could persist even longer, for several reasons. First, consumption is likely to remain below pre-recession levels for some time, implying a lasting drag on sales tax revenues. Persistently high unemployment also means that income tax receipts are unlikely to return to pre-recession levels for several years. At the same time, the persistently high levels of unemployment are also putting upward pressure on social benefit spending, particularly unemployment insurance, Medicaid (health insurance for the poor) and welfare.

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Debt-to-GDP ratios by state

120

State and Local Government Debt

100

Federal debt portion

% of state GDP

80

60

40

20

0 Delaware Montana Oregon Rhode Island California New York Missouri Massachusetts New Jersey Nevada Pennsylvania Alaska Illinois South Carolina Texas Colorado Florida Washington Hawaii Kentucky Indiana Vermont Arizona Idaho Michigan South Dakota Ohio New Mexico Connecticut Mississippi Nebraska Maine Utah New Hampshire Alabama Minnesota Georgia Wisconsin West Virginia Kansas Tennessee Maryland Virginia Iowa Louisiana North Carolina Arkansas Oklahoma North Dakota Wyoming District of Columbia

Total debt-to-GDP ratios shown above include both municipal and federal debt. We pro-rated Federal debt according to the states GDP. Total debt expressed as % of states GDP.
Source: Global Insight, SIFMA, SG Cross Asset Research

Though revenues have begun to rise, helping to narrow overall budget shortfalls relative to last year, this may not be enough to offset the coming declines in fiscal stimulus money. The Center on Budget and Policy Priorities estimates that state budget gaps before the use of federal stimulus funds amounted to $200 bn in FY2010 and will be followed by $180 bn in FY2011 and $120 bn in FY2012. However, after the use of stimulus funds, the projected shortfall peaks in FY2011 (which for most states began on July 1, 2010). As such, the worst may not be over yet for state and local governments.
Projected state budget gaps with and without fiscal stimulus funds
Budget gaps offset by Recovery Act Rem aining budget gaps after Recovery Act FY 2009 -20 -$71 -70 -$39 -120 -$110 -$63 -$36 -$180 -220 USD bln -$200 -220 -$137 -$144 $260 bn over the next two years -$119 -70 FY 2010 FY 2011 FY 2012 -20

-$1 -$120

-120

-170

-170

The projected total budget shortfalls reflect state fiscal conditions at the start of the fiscal period, i.e. before deficitclosing actions are taken (i.e. before fiscal stimulus funds, budget cuts, tax increases and reserves). FY2010 was the worst year in terms of overall budget gaps. However, after adjusting for fiscal stimulus funds, FY2011 shortfalls are projected to be slightly larger.
Source: Center on Budget and Policy Priorities

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FY2010 budget shortfalls, % of state GDP

3.0

2.5

FY'2010 Budget Shortfalls, % of state GDP FY'2010 total shortfall = $200.1 bn

2.0

1.5

1.0

0.5

Oklahoma Pennsylvania

District of Columbia Florida

North Carolina New Mexico Vermont Nevada

New Hampshire Missouri

South Dakota

Massachusetts Kansas Wisconsin Minnesota

South Carolina Kentucky

Source: Center on Budget and Policy Priorities, SG Cross Asset Research

Box 1: Balanced budget amendment what does it mean for the states?
In principle, a balance budget amendment which has been adopted in some form by 49 US states (except Vermont) means that the state cannot spend more than its income. In practice, the implications are not as straightforward. Thats because the balanced budget amendment applies to the state governments general fund which receive all tax and fee collections and are subject to legislative appropriations. The general fund excludes several important items:
Q Q

Federal grants, which are typically committed for specific purposes Transportation funds raised from gasoline taxes, which are earmarked for highways and other

transportation purposes
Q Q

Tax collections apportioned to local governments Capital expenditures, which are part of the states capital budget (separate from the operating

budget) State general funds receive about 50%-60% of all revenue sources and only those funds are subject to the balanced budget amendment. The balance budget amendment means that states generally cannot finance operating shortages with long-term debt.

Unlike the US federal government or governments of troubled European countries which are issuing large amounts of debt to finance current budget gaps, state and local governments have less flexibility to do so. Most states have adopted balanced budget amendments which prevent them from accumulating deficits over time. Some states have taken unconventional measures to get around the requirement, such as delaying vendor payments, issuing IOUs or delaying tax refunds; however this simply pushes the budget gap into the next fiscal period. Given the size of projected budget gaps for the next few years, it is clear that states will have to address them via tax increases and/or spending cuts.

West Virginia

North Dakota

0.0 Connecticut Rhode Island Alaska Oregon Georgia Maine New Jersey Illinois Arizona Washington California Hawaii New York

Tennessee Arkansas Nebraska Texas

Mississippi Iowa

Alabama Utah Virginia Delaware

Ohio Michigan

Louisiana

Wyoming Montana

Idaho Maryland

Colorado Indiana

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What are the problems in problem states?

As mentioned earlier, the problem currently facing states and local government is not the accumulation of earlier deficits, but rather the current and projected deficits that are a product of an unusually severe recession. The states facing largest budget gaps tend to have the worst-performing economies with high unemployment rates and foreclosure rates above national averages. As a result, these problem states have experienced the largest revenue drops while their costs have ballooned.
What do problem states have in common?
Budget gap - % of General Fund Budget 2010 estimate California Arizona Nevada Illinois New Jersey New York Rhode Island Kansas Alaska Oregon Florida Vermont Oklahoma Washington Maine New Hampshire Connecticut Hawaii North Carolina Georgia Wisconsin Colorado Pennsylvania Iowa Alabama Virginia Idaho Minnesota Utah Missouri Louisiana Maryland South Carolina Mississippi New Mexico Massachusetts Delaware Kentucky Ohio Michigan Tennessee Indiana Texas Nebraska Arkansas West Virginia South Dakota Wyoming Montana North Dakota National Avg 64.5% 57.9% 47.6% 40.9% 38.4% 38.0% 33.0% 32.9% 30.7% 29.0% 28.5% 28.1% 28.0% 27.8% 27.6% 27.5% 27.0% 26.4% 26.2% 26.1% 23.8% 23.3% 23.3% 22.7% 22.5% 22.5% 22.4% 22.3% 22.2% 21.8% 21.6% 21.1% 20.0% 18.7% 18.0% 17.7% 17.2% 14.5% 14.0% 12.4% 11.1% 10.6% 9.8% 9.0% 8.7% 8.0% 4.3% 1.7% 0.0% 0.0% 15.2% Budget gap Budget gap $ bln % of state GDP 2010 estimate 2010 estimate 54.6 5.1 1.5 14.3 11.0 21.0 1.0 1.8 1.3 4.2 6.0 0.3 1.6 6.2 0.8 0.4 4.7 1.2 5.0 4.5 3.2 1.6 5.9 1.3 1.6 3.6 0.6 3.4 1.0 1.7 1.9 2.8 1.2 0.9 1.0 5.6 0.6 1.2 3.6 2.8 1.1 1.4 3.5 0.3 0.4 0.3 0.0 0.0 0.0 0.0 200.1 3.0% 2.0% 1.1% 2.3% 2.3% 1.8% 2.1% 1.5% 2.7% 2.6% 0.8% 1.2% 1.1% 1.9% 1.7% 0.7% 2.2% 1.9% 1.2% 1.1% 1.3% 0.6% 1.1% 1.0% 0.9% 0.9% 1.1% 1.3% 0.9% 0.7% 0.9% 1.0% 0.8% 1.0% 1.2% 1.5% 0.9% 0.8% 0.8% 0.7% 0.4% 0.5% 0.3% 0.4% 0.4% 0.5% 0.1% 0.1% 0.0% 0.0% 1.1% Debt / state GDP 2010 estimate 29.5% 22.8% 25.1% 24.5% 26.0% 29.4% 30.2% 18.3% 25.0% 33.4% 23.4% 22.8% 13.3% 23.2% 19.9% 19.3% 20.8% 23.2% 14.5% 19.0% 18.8% 23.7% 25.0% 15.3% 19.2% 15.7% 22.2% 19.2% 19.9% 28.8% 15.0% 17.1% 24.2% 20.6% 21.2% 26.2% 45.6% 23.0% 21.3% 22.1% 18.2% 22.8% 23.8% 20.5% 13.5% 18.5% 21.4% 11.3% 41.2% 13.1% 22.2% Change in revenue Q1'2008 Q1'2009 -16.2% -16.5% 1.5% -10.9% -15.8% -17.0% -12.5% -11.1% -72.0% -19.0% -11.5% -7.2% -12.6% -9.0% -11.0% -2.5% -11.4% -10.2% -7.6% -19.1% -11.2% -10.1% -5.5% 3.6% 3.0% -19.9% -14.2% -9.7% -3.4% -1.3% -8.8% -1.2% -11.0% -7.6% -12.8% -16.8% -3.0% -3.8% -9.0% -16.5% -10.2% -3.5% -8.8% -5.5% -4.2% -9.4% -6.2% 19.7% 3.2% -12.1% -11.7% Unemployment Rate May-10 12.4% 9.6% 14.0% 10.8% 9.7% 8.3% 12.3% 6.5% 8.3% 10.6% 11.7% 6.2% 6.7% 9.1% 8.0% 6.4% 8.9% 6.6% 10.3% 10.2% 8.2% 8.0% 9.1% 6.8% 10.8% 7.1% 9.0% 7.0% 7.3% 9.3% 6.9% 7.2% 11.0% 11.4% 8.4% 9.2% 8.8% 10.4% 10.7% 13.6% 10.4% 10.0% 8.3% 4.9% 7.7% 8.9% 4.6% 7.0% 7.2% 3.6% 9.7% Prime foreclosure rate Apr-10 2.6% 3.1% 6.3% 3.7% 4.0% 2.6% 1.9% 1.3% 0.7% 1.8% 9.8% 1.8% 1.8% 1.3% 2.6% 1.2% 2.3% 3.3% 1.4% 2.1% 2.4% 1.4% 1.6% 2.0% 1.0% 1.1% 2.1% 1.5% 1.8% 1.1% 1.9% 2.0% 2.0% 1.7% 2.0% 1.7% 2.3% 2.0% 3.1% 2.1% 1.2% 2.9% 0.9% 0.9% 1.1% 1.3% 0.8% 0.8% 1.2% 0.5% 2.7% Sub-prime Needs foreclosure supermajority? rate Apr-10 13.2% 11.9% 19.0% 16.8% 24.8% 19.8% 10.7% 7.9% 7.3% 12.7% 30.6% 15.9% 10.2% 10.1% 16.4% 8.8% 15.6% 15.8% 6.6% 8.3% 15.8% 9.5% 10.3% 12.0% 5.4% 7.0% 11.2% 10.8% 12.4% 5.8% 10.7% 11.5% 10.9% 6.5% 10.3% 13.6% 16.2% 11.6% 12.5% 7.8% 5.5% 11.1% 5.7% 7.0% 5.5% 6.9% 10.9% 6.6% 11.3% 8.2% 13.6% Yes Yes Yes No No No Yes No No Yes Yes No Yes Yes No No No No No No No Yes No No No No No No No Yes Yes No No Yes No No Yes Yes No Yes No No No No Yes No Yes No No No

Source: Center on Budget and Policy Priorities, Global Insight, SG Cross Asset Research

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Based on 2010 budget gaps projected before any deficit-closing actions were taken, the states facing the strongest budget pressures include some of the usual suspects, in the following order: California, Arizona, Nevada, Illinois, New Jersey and New York. Unemployment in these states averaged at 11.3% in May vs. the national average of 9.7%. As of April, the problem states recorded a prime foreclosure rate of 3.9% vs. 2.7% nationally and a sub-prime foreclosure rate of 17.1% vs. 13.6% nationally. Another problem facing some states is the requirement for a supermajority vote (2/3 or in some cases or 3/5) for the approval of budgets and tax increases, which can make it very difficult to make the necessary cuts. This has been a chronic problem in California which is currently functioning without a budget.

Whats the damage?

States in austerity
During fiscal year 2010, state government resorted to a variety of methods to close their budget gaps. Significant cuts were made in education, transportation, Medicaid and in the corrections department. States instituted layoffs and furloughs, reduced salaries, cut employee benefits, raised tuition, boosted transportation fees and reorganized agencies. States also enacted over $20 bn in tax and fee increases which included sales tax hikes, higher gasoline and tobacco prices and in some cases higher personal income taxes. These austerity measures have been a drag on growth, both directly via lower government spending, and indirectly via higher taxes.
State austerity already hurting growth more to come
10 3m ann % 8 60 6 40 4 monthly change 80

20

0 0 -2

State and Local Government Spending (LHS) State Employment (RHS)

-20

-4

2 qtr moving averages

-6 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 -40

Source: Global Insight, SG Cross Asset Research

If no more federal stimulus funds are made available which is most likely going to be the case states will need to take further steps to close the projected $144 bn FY2011 shortfall. In direct terms, this translates to roughly 1% of GDP; however the impact on the economy will depend on the types of measures taken. Spending cuts would likely translate to a more direct hit to demand. Tax increases, particularly those on the wealthy, are likely to have lower multiplier effects, producing a more modest hit to growth.

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How states solved their 2010 budget gaps

40

# of states taking action

35 30 25 20 15 10 5 0
U se rf du ee ca s tio C Tr ou n an r f e t sp es re or la te at d io f n ee Bu re s la si te ne d ss fe re es la te d fe es La yo ffs Fu rlo Ea u rly gh s re tir Sa C e ut la m s ry en to re t em du ct Ac pl io oy ro n ee ss s -th be ene bo fit ar s d % R ed Ta cu uc ts rg e et ai ed d cu to R ts lo eo ca rg l g an o vt iz 's e ag en ci Pr es iv at iz R at ai io ny n G da Lo am y tte in f un ry g/ d ga ex m pa bl n in si g on ex pa ns io n he re
Brokers and dealers Banks Insurance Companies Rest of the world Other

Source: National Governors Association

Ownership of municipal debt limited exposure of the banking sector

H ig

Financial contagion risks lower than sub-prime or Greece

While the economy can probably survive state austerity, its chances for sustaining the recovery would become much slimmer in the event of financial contagion. The sharp widening in CDS spreads certainly raises concern, particularly in light of recent European experience. However, the key to the contagion issue lies in who owns the debt.

$2.8 trln outstanding

Funds (mmkt, mutual, closedend) Households

Source: Global Insight, SG Cross Asset Research

The European sovereign crisis became contagious because banks were significantly exposed to the troubled governments. In the case of state and municipal debt, the situation is very different. The ownership of municipal debt is dominated by US households which own about 70% of the $2.8 trillion outstanding, either via direct holdings or via money market and mutual funds. Banking institutions hold just 10%, or $270 bn. For US commercial banks, municipal holdings make up just 1.5% of their assets (vs. 1.7% of assets in Treasury debt).

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US states vs. EMU members

We can draw many parallels between US state governments and those of individual EMU members. In both cases, the governments in question have no independent monetary policy that can be tailored to the specific regional economy and its problems. They also have no independent currency that can be used as a macroeconomic tool.
EMU states vs. US states

EMU Countries
Independent currency/monetary policy Macroeconomic policy function (fiscal) Budget rules No Yes Imposed from above, though discipline has been uneven

50 States
No No Most states have adopted balanced budget amendments; room for maneuver varies across states No expectation of direct bailout, but fiscal support common (e.g. stimulus funds, Buy America Bonds) Possible within normal open market operations (but limited to 6m maturities) Yes for municipal debt, no for state Lower bulk of municipal debt owned by households

Parental support?

Recently made explicit with EFSF (though with strings attached and capped). Ongoing

Central bank intervention?

Default mechanism? Financial contagion risks?

No Higher large debt ownership by banking institutions

Source: SG Cross Asset Research

However, we see several important differences that suggest lower risk of contagion from potential defaults in the municipal debt market. In addition to the weaker financial linkages discussed earlier, there are also important institutional differences. When the European debt crisis first broke out, there was no institutional framework in place to support states facing funding problems. Some of those shortcomings have been addressed, but only after the initial damage to the financial markets. In the US, the institutional framework is not perfect, but it is much better defined than it was in Europe six months ago. First, the Fed has the ability to purchase municipal debt under normal open market operations (albeit limited to 6m maturities). Another big shortcoming for Europe has been the lack of shared fiscal responsibility. In the US, fiscal help for states is subject to political winds, but the risk is nonetheless much smaller when only one fiscal authority is involved. There is a strong precedent for fiscal support of the states. Lastly, the US also has institutional support for banks in the form of FDIC insurance. The absence of deposit insurance in the European banking system contributed to financial contagion risks during the recent sovereign crisis Another difference between US states and EMU members is that state governments share responsibility for many services with the federal government. In the unlikely event of a state default, the federal government would continue to pay social security, Medicare and other programs funded at the federal level.

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Box 2: Federal vs. state government - who pays for what?

Services paid for by the federal government:
Q Q Q Q Q Q

Social Security Defense Welfare (including food stamp programs) Medicare (healthcare for the elderly) Medicaid (healthcare for the poor shared with states)

Education (basic costs covered by the states, but the federal government funds various specialized programs)
Q Q Q Q Q

Employment/job training (incl. long-term unemployment benefits) Public housing assistance Transportation Postal service Hospitals

Services provided by state and local governments:

Q Q Q Q Q Q Q

Education (elementary, secondary and higher) Medicaid (healthcare for the poor shared with the federal government) Unemployment benefits (extended benefits shared with federal government) Transportation State police, fire protection Hospitals Parks and recreation

Defaults in the municipal debt market

State defaults are extremely rare. There has only been one state default in the past 110 years. Arkansas defaulted during the Great Depression and functioned on federal money for two years. Prior to that, several states also defaulted in the 1840s following a banking panic and a five-year recession.
Chapter 9 bankruptcy filings by municipalities
20 18 16 14 12 10 8 6 4 2 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: United States Courts

# of filings per year

10

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Municipal defaults are more common although less frequent than corporate defaults. Most municipalities that miss a payment generally make up for it within a few months. For those defaults that do end up restructuring their debt, this is done via Chapter 9 proceedings. Since 1937, there were only 616 Chapter 9 filings. Since 1980, 245 cases were filed, and about 1/3 of those were dismissed by court without any debt adjustment. Box 3: Debt restructuring mechanism for state and local governments
A state is a sovereign and as a sovereign it cannot file for bankruptcy. There is no legal process for restructuring state debt. Municipalities file for bankruptcy protection under Chapter 9 proceedings. This is different than businesses which file under Chapter 7 (liquidation) or Chapter 11 (reorganization). Key features of Chapter 9 protection include:
Q

Only the debtor can initiate Chapter 9 proceedings involuntary bankruptcies are not permitted in

the municipal world

Q Q

Chapter 9 allows for adjustment of debts, not for liquidation Bottom line: municipality continues its existence in bankruptcy, and often continues to pay its debt.

The court cannot decide what services will be provided by the governmental body.

Some states have statutory provisions to authorize (or block) municipal bankruptcy filings. The state can:
Q Q Q Q

Offer bridge financing or refinancing of the trouble debt Offer grants to the municipality to bridge financing crisis Transfer services to other governmental agencies to reduce expenditures Use intercept of state tax payable to the municipality to ensure essential services

Default stats
Municipal defaults are not uncommon. However, municipal bonds have historically exhibited much lower default rates and higher recovery rates than corporate bonds. In a recent study based on the 1990-2007 period, Fitch found that the cumulative five-year default rate on investment-grade municipal debt averaged at 0.1% compared with 1.2% for corporates. These results are broadly in line with a recent Moodys study, the results of which are shown in the table below. Average recovery rates are also significantly higher on municipal debt. The ultimate recovery rate has averaged at 67% on municipal issues vs. 38% on senior unsecured corporate bonds. Municipal default rates typically lag the economic cycle, given the delayed impact of recessions on state budgets. Most municipal defaults are concentrated among weaker credits and weaker purposes, such as hospitals and housing bonds. Stronger purposes, such as utilities, universities, or even general obligation bonds tend to default less frequently given a greater ability to collect on their receivables.

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Default Rates: municipal vs. corporate debt

10-year cumulative Default Rates Aaa Aa A Baa Ba B Caa to C Investment Grade Speculative Grade All Rated Municipal Bonds 0.00% 0.03% 0.03% 0.16% 2.80% 12.40% 11.60% 0.06% 4.55% 0.09% Corporate Bonds 0.50% 0.54% 2.05% 4.85% 19.96% 44.38% 71.38% 2.50% 34.01% 11.06%

Recovery Rates: municipal vs. corporate debt

Municipal Bonds 30-day post-default price Ultimate recovery rate (avg) Ultimate recovery rate (median)
* based on data from 1987 to 2007

Senior Unsecured Corporate Bonds 37.5% 38%* 30%*

59.9% 67.0% 85.0%

The data above covers the period from 1970-2009. Based on a study that covers only Moodys rated bonds. There were 18,400 bonds in the sample as of 2009.

10-year cumulative default rate is the percentage of bonds that ended up in default 10 years after issuance
Source: Moodys

It is important to keep in mind that in the case of general obligation bonds which are backed by the full faith and credit of the local governments, a decision to default is largely political. While it is politically difficult to raise taxes of lay off public sector workers, the implications of defaulting and being shut out of the debt markets are far more severe. This is why local governments generally tend to side with bondholders rather than the constituents.

Bailout options
Our central scenario is that states will close their projected gaps by spending cuts and/or tax increases. Municipal default rates will likely rise, but that is normal following recessions and is expected by the market. Bailouts for states and/or municipalities are not very likely at this stage. Indeed, the heads of President Obamas debt commission recently told governors not to count on the federal government for more budget bailouts. The only scenario in which we envision more aid for state and local governments is one in which a rise in defaults spooks investors and triggers widespread funding problems in the municipal market.

Central bank able, but not willing

The Feds ability to purchase state and local government debt is clearly spelled out in section 14 of the Federal Reserve Act. This ability is part of normal market operations, not emergency powers. The Fed can buy securities issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality in the continental United States, including irrigation, drainage and reclamation districts. However, there is an important restriction built into the stature which limits the Feds buying to municipal securities maturing within six months of the purchase. Since municipal debt tends to be long-dated, we estimate that this limits the Feds buying ability to only about $100 bln. Despite its ability to purchase municipal debt, historically, the Fed has been reluctant to do so. Municipal debt purchases were considered in the late 1990s when the Treasury was running fiscal surpluses and reducing the amount of debt outstanding. The Fed needed alternative

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asset classes to conduct open market operations. After considering municipal debt, the Fed decided against it. The Fed also did not intervene in the municipal market in late 2008 and 2009 despite significant dislocations and some political pressure. We conclude that the Fed intervention in the market is unlikely and, in the event of disruptions in the municipal debt market, the first round of aid would come from the federal government.

Federal government strong precedent of bailouts

There is no explicit mechanism for Federal bailouts of failing states or municipalities. However, there is a strong precedent. Following the default of Arkansas in 1933, the state functioned on federal money for two years (until it passed a sales tax). There are also more recent examples of federal aid for cash-strapped state and local governments.
Q

Last years stimulus funds. As part of the American Recovery and Reinvestment Act

(ARRA) of 2009, the federal government earmarked about $140 bn (1% of GDP) in direct relief to state and local governments to be distributed over a roughly 2 year period. The funds, which cover about 30% of projected state shortfalls, largely took the form of increased Medicaid funding and a State Fiscal Stabilization Fund. Stimulus money has reduced the extent of state spending cuts and state tax increases.
Q

The Build America Bonds program. The program was introduced on February 17, 2009,

as part of the ARRA. These are taxable municipal bonds that carry special tax credits or direct federal subsidies. All issuance to date has been in the direct-pay BABs, where the Treasury Department provides borrowers with cash subsidy payments equal to 35% of their interest costs. With tax-credit BABs, investors receive the right to a federal income tax credit equal to 35% of their BAB interest income. The tax credit can be carried forward to future years if the bondholders tax liability is insufficient in a given year. The net effect in either case is substantially reduced interest expense to state and local governments. Unlike tax-exempt debt, normally issued by state and local government, BAB bonds are attractive to taxpayers in lower tax brackets or to those that do not pay income taxes (e.g. pension funds, endowments or foreign investors). Since the launch of the program, $180 bln in Buy America Bonds have been issued, or about 20% of total municipal issuance. Under current law, the program is open to bonds used to finance capital expenditure projects and issued before January 1, 2011.

How much aid may be needed?

The total projected budget shortfall for FY2011 is about $145 bn. While this gap will be closed at least partially via austerity measures, in the worst case scenario we can assume that the burden will fall back on the federal government. This amount is roughly equal to the relief fund for states included in the 2009 fiscal stimulus package. Refinancing needs for states are relatively low given the long-term nature of most municipal debt. We estimate that about $200 bn in municipal debt is maturing over the next 12 months, or 7% of all issues outstanding. In the worst case scenario, whereby the municipal debt market shuts down completely, the federal government may have to provide $350 bn in aid. This is equivalent to 2.4% of US GDP. This would roughly offset the expected improvement in the federal deficit over the next year.

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How vulnerable is the Treasury market?

Unlike Japan, which is facing a chronic savings surplus, the US is facing a chronic savings deficit. Market mechanisms to resolve this problem are higher bond yields and/or weak currency. For now, massive portfolio flows into the US are delaying these adjustments and keeping Treasury yields artificially low. However, the heavy reliance on ongoing purchases is precisely the reason for our upside bias on Treasury yields. In our baseline scenario we assume a gradual adjustment toward higher yields and higher savings rates, offset by a shrinking trade deficit. However, the 2007 episode taught us an important lesson that we should not become too complacent on the ability of the US economy to finance its external deficit. In 2007, the main source of financing was the sale of structured credit assets which came to an abrupt stop. The savings deficit is now being financed via sales of US Treasury debt which has its own fundamental issues. Indeed, federal government is facing greater fundamental challenges than state and local governments.
Foreign Private Purchases of US Assets
70 60 50 40 30
5

Foreign Official Purchases of US Assets

25

Treasury Agency Corp Bonds Equity

10 20

Treasury Agency
15

Corp Bond

20
0

10 0 -10 -20 95 97 99 01 03 05 07 09
-5 -10 -15 95 97 99 01 03 05 07 09

Source: Global Insight, SG Cross Asset Research

Given the ongoing reliance on external financing, we cannot ignore the possibility that foreign investors might lose confidence in the US government and significantly reduce their purchases of Treasury debt. It is not clear what might cause such a scenario, but another bailout for state and local governments could be a potential trigger. In the event of a municipal debt problem and contagion to the Treasury market, we believe that the Fed would step in and become a buyer of government paper. To the extent that the Feds purchases are successful in capping bond yields, the dollar would become the main adjustment variable.

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Conclusions
State austerity is the only sustainable solution to the current budget woes. In this regard, state and local governments are similar to the troubled EMU members. We see the risk of financial contagion as less pronounced than in the case of sub-prime mortgages or Greece. We see a state default as highly unlikely. A rise in municipal defaults is likely and normal following a deep recession. Higher municipal defaults are expected by the market. The main risk would be above-normal defaults rates, or defaults occurring in unusual segments of the municipal market such as general obligation bonds and/or revenue bonds backed by stronger purposes (utilities, education). This could spook investors and trigger funding problems for state and local governments. If this occurs, we see the following as the most likely sequence of responses:
Q

The first round of help would likely come from the Federal government rather than the

Fed.

Another stimulus package with relief funds for local governments. More direct intervention is less likely, but could occur in the event of a state funding

crisis.

Market impact: There is some risk that Federal support for states might spook foreign

buyers of Treasury debt. This would also weigh on the dollar.

Q

In the event of contagion, the Fed would likely step in to support the Treasury market.

Monetization is the end game in this scenario.

Market impact: Fed purchases could cap bond yields, but the dollar would suffer.

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SG Forecasts
The US economy lost some momentum since late spring and we have our recently 2010
Real GDP Real Final Sales Consumption Non-Resid Fixed Investment Business Structures Equipment and Software Residential Inventories Chg, % contibut to GDP Net Trade, % contribut to GDP Exports Imports Government Spending Federal Govt State & Local PCE Deflator PCE Core CPI CPI Core Unemployment Rate Personal Income Disposable Personal Income Real Disposable Pers. Income Savings Rate Corp Profits

Economic forecasts
Quarterly Annualized Growth Rates 2009 A 2010 E 2011 E Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2
2.2 1.5 2.8 5.6 1.7 1.6 2.7 0.8 3.0 3.2 3.0 3.3 3.1 2.9 3.3 2.9 2.8 3.0 7.6 -5.0 12.0 10.0 0.1 -0.5 6.0 8.0 0.3 2.2 -1.0 2.0 1.2 2.2 1.2 9.5 4.4 3.8 1.8 3.6 15.0 2.6 2.6 2.6 7.6 0.0 10.0 10.0 0.0 -0.5 5.5 8.0 1.7 2.0 1.5 1.5 1.3 1.7 1.3 9.4 4.7 4.1 2.6 3.5 10.8 2.3 2.5 2.7 5.3 0.0 7.0 10.0 -0.1 -0.5 5.5 8.0 1.6 1.7 1.5 1.6 1.5 1.8 1.6 9.2 4.7 4.2 2.6 3.5 8.1

Annual year/year 2008 2009 2010 2011

A
0.4 0.8 -0.2

downgraded

A
-2.4 -1.7 -0.6

E
3.1 1.9 2.6

E
2.7 2.6 2.9 7.0 -2.3 10.1 8.0 0.0 -0.5 6.2 8.2 1.1 2.0 0.4 1.6 1.3 1.7 1.3 9.1 4.6 4.2 2.6 3.4 10.9

forecast form 3.8% to 3.1%. The reasons for the slowdown are totally clear, but may reflect a combination of expiring stimulus programs and some spillover effects from the European debt crisis. We still see the odds tiled towards sustaining the recovery, albeit at a slower pace than previously thought. The consumer is still supported by decent income gains and the capex cycle remains strong underpinned profit by growth.

-5.9 5.3 2.2 8.5 8.1 -18.4 -18.1 -15.5 -10.0 -10.0 1.5 19.0 11.4 16.0 15.0 18.9 0.7 -0.8 17.8 21.3 2.7 8.0 -0.6 2.6 1.2 3.7 1.5 9.6 -1.4 -1.2 -3.6 3.9 50.7 3.7 -10.3 3.7 0.3 22.8 15.8 -1.3 0.0 -2.2 2.5 1.8 2.6 1.5 10.0 2.2 2.5 0.0 3.7 36.0 1.9 -0.8 11.3 14.8 -1.9 1.2 -3.8 1.5 0.6 1.5 0.0 9.7 3.9 3.7 2.1 3.5 35.9 3.0 0.2 -0.3 10.0 10.0 0.1 3.3 -2.0 -0.4 0.9 -0.8 0.8 9.7 5.0 5.5 5.9 3.9 8.6 5.0 0.2 -0.4 8.0 9.0 0.1 2.5 -1.5 1.4 1.1 1.6 1.0 9.6 4.3 4.0 2.6 6.8 12.4

1.6 -17.8 3.2 10.3 -19.8 -14.3 -2.6 -16.6 11.8 -22.9 -20.5 -0.3 -0.6 0.2 1.2 -0.5 12.1 11.6 0.1 3.0 -1.8 1.5 1.1 1.6 1.0 9.6 3.2 3.5 2.0 4.5 25.9

0.7 0.9 5.4 -9.6 -3.2 -13.9 3.1 7.7 0.5 3.3 2.4 3.8 2.3 5.2 2.9 3.9 0.5 2.7 -11.8 1.8 5.2 -0.2 0.2 1.5 -0.3 1.7 9.3 -1.8 1.0 0.8 4.2 -3.8

However, confidence remains shaky. The inventory cycle is coming to an end and adds to the overall economic slowdown. Lastly, fiscal stimulus is peaking and though the fiscal drag should be gradual, it is nonetheless no longer adding to growth. The upcoming tax increases at the local and federal level are the key reason for our below-consensus forecast. The downside risks 2011

Source: BEA, SG Cross Asset Research

Rates and FX forecasts

Central Bank Rate Forecasts
US Canada
current 0.25 0.50 current 2.95 3.17 3 mths 0.25 0.50 3 mths 3.00 3.25 6 mths 0.25 0.75 6 mths 3.25 3.50 9 mths 0.25 1.25 9 mths 3.50 4.00 1 yr 0.50 1.75 1 yr 4.00 4.50

on

10 year bond yields

US Canada

growth and inflation suggest that the Fed should remain on hold through mid-2011. In the context of steady Fed policy, we see limited upward pressure on bond yields over the next 6 months. Longer, term, a sustained recovery should start to push bond yields higher, particularly as the Fed signals tightening.

FX rates
USD per EUR USD per GBP CAD per USD JPY per USD
Source: SG Cross Asset Research

current 1.30 1.53 1.05 87.0

3 mths 1.20 1.50 1.00 90.0

6 mths 1.20 1.52 0.98 92.0

9 mths 1.15 1.50 0.96 94.0

1 yr 1.10 1.50 0.95 96.0

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SG Proprietary Indicators
Our Business Cycle index suggests that the economy is slowing from 4% pace in Q4-Q1 towards 2% pace. This is above our current GDP forecasts and suggests further downside risks. However, some of the recent weakness reflects movements in financial variables which could bounce back. Highfrequency economic indicators have stalled, but are not showing renewed deterioration. Overall, the BCI is consistent with a loss of momentum, but argues against a doubledip scenario. Our real-time recession tracking model now updated through May shows very slim chances that the economy is entering recession.
100%
1 .0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 1 0 Real-time recessio n pro babilities are derived fro m a regime switching mo del using the same fo ur co incident indicato rs used by NB ER cycle dating co mmittee. These include: emplo yment, real inco me, real sales (retail + business) and industrial pro ductio n NB ER recessio ns M o deled Rec. P ro b

SG Business Cycle Index

5 6 4 0 2 0 -2 -1 0 SG US B usiness Cycle Index (LHS) GDP , 2 qtr mo ving average (RHS) -1 5 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 1 0 -6 -4

-5

SG Real-Time Recession Probability Model

SG Fed Model
Rate Cut Probability
Latest Probabilities
100% 63% 40% 15% 72% 80% 60% 40% 20% 0% 3M 6M 9M Probability of at least one rate hike w ithin the next 3, 6, 9 and 12 months 12M 0% 0% 1% 5% 80% 60% 40% 20% 0% 3M 6M 9M 12M probability of at least one rate cut w ithin the next 3, 6, 9 and 12 months

Rate Hike Probability

Our fundamentally-derived Fed probability models show slim chances that the Fed will be hiking rates in the next 12 months, although the chances of additional rate cuts (read: additional easing) have been fading. the Fed has opened the door for a possible resumption of quantitative easing, but the economy would have to deteriorate much further before the Fed takes such a step.

Historical Perspective - 6 month ahead probability

100% 80% 60% 40% 20% 0% 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 rate cuts Probability of at least one rate cut w ithin next 6 months 100% 80% 60% 40% 20% 0% 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 rate hikes Probability of at least one rate hike w ithin next 6 months

Probability derived from a probit model based on employment, core inflation, ISM index and a liquidity index
Source: SG Economic Research

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Rates and Short-term Funding

Rates
Fed Funds Expectations
1 .00 %
Lat est Week ago M onth ago

Treasury Yield Curve (10y - 2y)

3.5 3.0 2.5 2.0

Market expectations for rate hikes have been pushed back notably over the past two months. Double-dip concerns and renewed deflation fears have triggered bullish flattening of the Treasury yield curve. Inflation breakevens have declined to lowest levels since October 2009. Funding pressures tied to the European sovereign crisis have eased somewhat, but funding spreads remain significantly above April levels.

0.75

0.50

0.25

1 .5 1 .0 7/1 0 9/1 0 1 1 /1 0 1 /1 1 3/1 1 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0

0.00

Real Treasury Yields

2.5 2.0 1 .5 1 .5 1 .0 0.5 0.0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0 1 .0 0.5 0.0 1 /09
5yr real 10yr real

Inflation Expectations
3.0 2.5 2.0

10yr breakeven 5yr 5yrs f orward

4/09

7/09

1 0/09

1 /1 0

4/1 0

7/1 0

Short Term Funding

Libor vs. OIS (3m) - Historical and Implied
4.0 3.5 3.0 2.5 2.0 1 .5 1 .0 0.5 0.0 Jan07 A pr07 Jul07 Oct07 Jan08 A pr08 Jul08 Oct08 Jan09 A pr09 Jul09 Oct09 Jan1 0 A pr1 0 Jul1 0 Oct1 0 %

A1/P1 Nonfin CP vs. OIS (3m)

0.5 0.4 0.3 0.2 0.1 0.0 -0.1 -0.2 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0 3.5 3.0 2.5 2.0 1 .5 1 .0 0.5 0.0 -0.5 1 /09

ABCP vs. OIS (3m)

4/09

7/09

1 0/09

1 /1 0

4/1 0

7/1 0

Source: Bloomberg, SG Economic Research

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Credit Availability
Mortgages & Consumer Credit
Conforming Mortgage Rate
6.0 1 .60

Fannie/Freddie MBS Spreads

Fannie/Freddie M BS vs. swap

The European sovereign crisis and US double-dip concerns have triggered a rotation to safe haven assets and away from risk. Among risky assets, equities have been hurt the most. Corporate credit has been a bit more resilient, in part helped by declines in government bond yields. Mortgages have benefited the most. The 30yr fixed conforming rate has dropped to around 4.9%, matching the lows registered in 2003. This is a silver lining that offers some offset to the adverse impact of tighter financial conditions.

5.5 5.0 4.5 4.0 3.5 3.0 1 /09 4/09

30yr Fannie M BS 30yr Conforming M ortgage Rate

1 .20

0.80

0.40 7/1 0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0

7/09

1 0/09

1 /1 0

4/1 0

ABX AAA Tranches

1 00 90 80 70 60 50 40 30 20 1 /08 7/08 1 /09 7/09 1 /1 0 7/1 0 200 0 1 /09 index
2006- 1 2006- 2 2007- 1 2007- 2

Consumer ABS Spreads

1 200 1 000 800 600 400 bp
credit cards autos

4/09

7/09

1 0/09

1 /1 0

4/1 0

7/1 0

Corporate Credit
Swap Spread (10yr)
50 40 30 20 1 0 0 -1 0 -20 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0 1 00 50 0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0 300 250 200 1 50

Inv Grade Corp Spread

DJ Inv Grade CDX Index

HY Spreads
(Lehman HY - 10yr Sw ap)
2200 2000 1 800 1 600 1 400 1 200 1 000 800 600 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0 450 400 350 300 250 200 1 50 1 00 50 0 1 /09

Sector CDS Spreads

Financials Industrials

4/09

7/09

1 0/09

1 /1 0

4/1 0

7/1 0

Source: Bloomberg, SG Cross Asset Research

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FX Monitor
Dollar
Major Dollar Index
88 86 84 82 80 78 76 74 72 70 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0 20 1 5 1 0 5 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0 30 25

FX Volatility (G10 avg)

The dollar has benefited from the European sovereign crisis, but recently gave back some of those gains. The reversal reflects a rotation of economic fears from Europe to the US. The data has been weak in the US while large European economies are benefiting from the weak currency. Additionally, there is a sense that European policymakers are finally addressing some of the institutional weaknesses that have led to the crisis (EFSF, ECB purchases of sovereign debt, bank stress tests). Over the next 12 months, we see the dollar gaining further as the US avoids a double-dip recession while the European periphery continues its struggle with austerity.

USD/EUR
1 .6 1 .5 1 .5 1 .4 1 .4 1 .3 1 .3 1 .2 1 .2 1 .1 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0 1 05 1 00 95 90 85 80 1 /09 4/09

JPY/USD

7/09

1 0/09

1 /1 0

4/1 0

7/1 0

Carry Trade Index

1 70 1 60 1 50 1 40 1 30 1 20 1 1 0 1 00 1 /00 7/00 1 /01 7/01 1 /02 7/02 1 /03 7/03 1 /04 7/04 1 /05 7/05 1 /06 7/06 1 /07 7/07 1 /08 7/08 1 /09 7/09 1 /1 0 7/1 0

Carry-to-Risk Ratio
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 99 00 01 02 03 04 05 06 07 08 09 1 0
35

% M o re attractive

Yield Differential
6.0 5.0 4.0 3.0 2.0 1.0

+/- 1St Dev range

00

01 02

03

04

05 06

07 08

09

10

Im plied Vol
Less attractive
25 15 5 00 01 02 03 04 05 06 07 08 09 10

Source: Bloomberg, SG Cross Asset Research

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Commodities and Equities

Commodities
Crude Oil (Nymex WTI)
1 00 1 300 1 200

Gold

European austerity, double-dip fears in the US and growing concerns on China have created a difficult backdrop for commodities. Aside from double-dip fears, the global inventory cycle is coming to an end now that production has converged to demand. This by itself has reduced demand for commodities. While we may not see a resolution to the above concerns in the near-term, we believe that the global economy will ultimately overcome the headwinds and avoid a double-dip. Sustaining the global recovery should underpin commodity demand and be supportive for risk appetite.

80

1 1 00 1 000

60

900 800 700 600

40

20 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0

500 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0

Copper
400 350 300 250 200 1 50 1 00 50 0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0 5000 4500 4000 3500 3000 2500 2000 1 500 1 000 500 1 /09

Baltic Dry Index

4/09

7/09

1 0/09

1 /1 0

4/1 0

7/1 0

Equities
Sector Performance - 4 wk chg
Co nsumer Staples Utilities Teleco m Health Care IT M aterials Financials Industrials Energy Co nsumer Discretio nary - 0 .2 % - 0 .7 % - 2 .7 % - 3 .7 % - 4 .3 % - 4 .6 % - 4 .9 % - 6 .4 % - 6 .9 % - 8 .7 %

VIX
60 50 40 30 20 1 0 0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 7/1 0 1 8 1 6 1 4 1 2 1 0 8 6 4 2 0

Volatility Skew
(25 delta put - 25 delta call, SPX Index)

1 /09

4/09

7/09

1 0/09

1 /1 0

4/1 0

7/1 0

Source: Bloomberg, SG Cross Asset Research

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