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July 28, 2011



US Debt Ceiling: Next Steps
David Greenlaw                                       Arnaud Marès                                           Betsy Graseck
Head of US Economics                                 Head of Sovereign Strategy                             US Large Cap Banks Research Analyst                          
+1 212 761-7557                                      +44 20 7677-6302                                       +1 212 761-8473
Morgan Stanley & Co. LLC                             Morgan Stanley & Co. International plc+                Morgan Stanley & Co. LLC

Introduction –            Welcome to our call today on the debt ceiling debate. With me are David Greenlaw, head of Morgan
Betsy Graseck             Stanley's US economics team, and Arnaud Marès, our head of sovereign strategy. For those of you who
                          don't know Arnaud, he was at Moody's up until a year ago. David will describe his view on the potential
                          outcomes around the debt ceiling debate. Arnaud will present his views on the likelihood of a sovereign
                          downgrade. I will describe how we're thinking about the impact of the debt ceiling debate on banks. And
                          then we will open up the call to Q&A.

Speaker: David Greenlaw
At this point the end game is obviously still very unclear. One                 not ability to pay. Treasury Secretary Geithner is in the middle
of the cautions that I've been raising for a while is that it's                 of a very dangerous game of chicken, but if push comes to
going to get worse before it gets better. And we may well be                    shove we think that the Treasury will always choose to service
at the low point at this stage because there is really no clear                 the debt and deal with the consequences later. Within the
resolution. However, there is still time.                                       Treasury they are gaming out all sorts of different scenarios,
                                                                                but none of those scenarios includes the inability to pay
I think a two-stage process seems most likely. Congress                         principal or interest. So there's a lot of uncertainty about how
could do something very short term to hike the debt ceiling,                    they're going to do it and what mechanism they will use. The
and the deal could have some spending cuts attached to it.                      mechanisms range all the way from disinvesting other trust
Then Congress could put in place some kind of mechanism                         funds to using the 14th amendment of the constitution.
aimed at achieving longer-term deficit reduction and avoiding
a ratings downgrade. I think there's a very good chance that                    Whatever they use, they will continue to make timely
we could go into the weekend without any real clarity on what                   payments of principle and interest, so there's no chance of a
the outcome will be.                                                            default in that sense. But there is a chance of some
                                                                                disruptions to the Treasury auction schedule. We've had such
But there are some very basic principles that are important to                  disruptions in the past around debt ceiling debates. In
keep in mind as we go through this. And right at the top of the                 particular, we have a mid-quarter refunding auction coming up
list from my standpoint is that there is absolutely no chance of                in early August, and there is a possibility that the auction could
a missed coupon or principal payment on the part of the US                      be impacted.
Treasury. If you take nothing else away from this call I think
that is the key takeaway. This is all about willingness to pay,

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July 28, 2011
U.S. Debt Ceiling: Next Steps

Exhibit 1                                                                                      Exhibit 2
A Credible Debt Deal is Needed to Stave Off a Sharp                                            Impact of Various Deficit Cutting Scenarios
Rise in Government Debt                                                                                    US Net Public Debt in 2021
 120                                                                                                                                                                       (% of GDP)
          Net Federal Debt as a % of GDP

                                                                                               Baseline (CBO "Alternative scenario")                                                 101
                                                                                               $2 trillion in deficit reduction                                                        85
                                                                                               $4 trillion in deficit reduction                                                        70
   60                                                                                          $6 trillion in deficit reduction                                                        60
                                                                                               Note: Keep in mind that the arithmetic in the table is based on real spending cuts or tax
                                                                                               increases. A package “claiming” $2 trillion in deficit reduction would probably imply a
   40                                                                                          debt/GDP ratio of at least 90% in 2021 given the typical amount of budgetary smoke and
                                                                                               mirrors in these types of initiatives.
                                                                                               Source: Committee for a Responsible Budget (CRFB) and Congressional Budget Office
   20                                                                                          (CBO)

    0                                                                                          If you wanted to bring the debt to GDP ratio down to 60%,
        1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
                                                                                               which is what most economists would say is needed for a
Note: CBO historical data and estimates for 2011 to 2021 based on their ‘Alternative Fiscal    sustainable fiscal policy, then you would need $6 trillion in
Source: Congressional Budget Office (CBO)
                                                                                               deficit reduction over the course of the next decade. Keep in
                                                                                               mind that this arithmetic is based on real deficit reduction, not
Also keep in mind from our perspective that there's only a                                     the kind of smoke and mirrors that is likely to be included in
slight chance of a ratings agency downgrade during the next                                    any deficit reduction package that is passed in the near future.
few months. Arnaud will talk about this in more detail, but let
me try to frame the debate around the prospects for a ratings                                  With the types of proposals that are being made today, I think
downgrade. In Exhibit 1, we show federal government debt as                                    you could take a 50% haircut on the headline number that is
a percent of GDP, combining historical data with estimates                                     provided to get an estimate of the likely real deficit reduction.
based on the CBO’s “alternative fiscal scenario.” It's a                                       So I think we will probably see some further increase in the
scenario that includes an extension of the expiring Bush tax                                   debt to GDP ratio going forward because I doubt we're going
cuts and the extension of other provisions of the tax code that                                to get $4 trillion of real spending cuts. But we could get
always get extended. So from the standpoint of most                                            something that puts in place a mechanism that slows the rate
economists, it is a reasonable baseline starting point.                                        of growth in the ratio significantly and avoids a ratings
                                                                                               downgrade. And again, Arnaud will talk more about that.
As you can see, the debt to GDP ratio in the US goes straight
                                                                                               Exhibit 3
up over the course of the next decade. Today it's about 69%,
                                                                                               Federal Government Revenues
but by 2021, ten years out, we'd be a little above 100%. That
is certainly an unsustainable policy path and is what the                                       22
                                                                                                      (% of GDP)

ratings agencies are focusing on and urging the US to                                           21

Exhibit 2 shows some basic rules of thumb for debt to GDP                                       19
outcomes. The CBO baseline estimate gives you a 101%
debt to GDP ratio at 2021. If you had $2 trillion in deficit                                    18

reduction you'd be at about 85%. If you had $4 trillion, you’d                                  17
be at 70%, and that would indeed be a stable debt to GDP
ratio. That's why there's a lot of focus in Washington on trying                                16

to achieve the $4 trillion number, because you would be                                         15
stabilizing the debt to GDP ratio with $4 trillion in cuts.
                                                                                                     55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15 18 21 24 27 30 33 36

                                                                                               Source: CBO “Long Term Budget Outlook,” June 2011 (using the ‘alternative fiscal scenario’)


July 28, 2011
U.S. Debt Ceiling: Next Steps

To highlight some of the basic arithmetic underlying the US                                   Over the next few decades that spending line goes up
fiscal position at this point, lets look at both the receipts and                             dramatically. And it goes up in large part because the interest
expenditures side of the equation. On the receipts side today                                 component is driving it much, much higher. That reflects two
we're around 15% of GDP for federal government tax                                            things. It reflects an expected eventual normalization of
revenues (Exhibit 3). That's very, very low, the lowest point                                 interest rates. So short-term interest rates get back to three or
on this chart which goes back to 1955. Indeed, it's as low as                                 four percent, long-term interest rates get back to five percent
we've been since the 1930s. It's low for understandable                                       or so. That's assumed to play out over the course of the next
reasons: We've just been through a very severe recession.                                     five to ten years. Also, you're piling a lot of debt on top of the
We've had a lot of tax cuts over the last decade, including the                               debt that's already there. And that's driving your debt service
Bush era tax cuts in 2001 and 2003, the payroll tax cut in                                    costs higher.
                                                                                              Economists like to look at what's called the primary budget as
If the economy recovers, if we get back to a 5 ½%                                             an indication of whether fiscal policy is sustainable in the long
unemployment rate over the course of the next five years or                                   term. So let's look at the primary spending numbers, the total
so ( that may be a questionable assumption, but let's use that                                spending excluding interest (shown in bold in Exhibit 4). Even
as a starting point), and assume that the 2011 tax cuts go                                    there we're seeing a dramatic escalation over the coming
away as well as the payroll tax cut and the accelerated                                       decades. We're at about 23% today, expected to go to 27%
depreciation provision. Under those assumptions, the tax                                      by 2050. So even before including the interest component of
receipts as a percent of GDP would get up to 18 ½% over the                                   the budget, you've got tax receipts at 18 and a half and you've
course of the next few years and would stabilize at about that                                got spending excluding interest eventually reaching 27, not
level. That is pretty consistent with the long-term average for                               sustainable by any stretch.
federal government tax receipts as a percent of GDP.
                                                                                              When you look at the components that are driving things,
So that's what's happening on the revenue side. But take a                                    social security gets a lot of attention. But social security is
look at the spending side. Exhibit 4 shows the outlook for                                    expected to go from about 5% of GDP today to about 6% in
federal government expenditures going forward.                                                40 years. That' will need to be addressed at some point, but
                                                                                              it's a modest escalation. Then look at healthcare, Medicare
Exhibit 4                                                                                     and Medicaid: 5 ½% of GDP today expected to go to 13% by
Federal Government Expenditures (% of GDP)                                                    2050, driven both by demographic factors and rising per
                                                                                              patient expenses.
FY                                               2010            2030            2050

Medicare and Medicaid                            5.5             9.2             13.0         This is a baseline that includes, I think, very unbiased and
                                                                                              realistic assumptions. But it doesn't include second round
Social Security                                  4.8             6.0             5.9
                                                                                              effects such as a lot of state governments trying to push their
Other noninterest outlays                        12.5            8.7             8.1          patient load into the Medicaid program when the healthcare
                                                                                              exchanges come into play in 2014. If something like that
Total Excluding Interest                         22.9            23.9            27.0         happens, you will see much higher rates of spending for
Interest                                         1.4             7.2             15.8         Medicaid. So I think these are unbiased estimates, but
                                                                                              perhaps a little bit lower than we're actually likely to see going
Total                                            24.3            31.1            42.8         forward.
Source: CBO “Long Term Budget Outlook,” June 2011 (using the ‘alternative fiscal scenario’)

                                                                                              It's clear that the major problem in the budget is healthcare.
Again, this is a CBO baseline using current policy, assuming                                  The problem is that recent polls in the US have consistently
some wind-down of defense spending and assuming that                                          shown that nearly 80% of Americans oppose any changes
everything else pretty much stays the way it is or the way                                    whatsoever to Medicare. That's why this is so politically
current law says it will be, including the imposition of health                               difficult to address, and why you're seeing so much difficulty in
care reform starting in 2014. So under this scenario, today                                   reaching a compromise agreement around a legitimate deficit
expenditures are 24% of GDP. With 24% spending versus                                         reduction program.
15% on the receipts side, you've got a budget deficit of close
to 10% of GDP.                                                                                So that's the basic budget arithmetic. Another important
                                                                                              question for economists in this environment is what happens
                                                                                              to the expiring stimulus programs. Exhibit 5 shows the
                                                                                              change in the US structural budget. We've had a fair amount


July 28, 2011
U.S. Debt Ceiling: Next Steps

of stimulus in recent years, and we're getting more stimulus in                                   interesting way of depicting the degree of polarization that's
2011 from the payroll tax cut. But if the payroll tax cut expires                                 out there. It's the result of some research by political
you'll have some significant fiscal restraint in 2012.                                            scientists who have quantified the degree of divergence in
                                                                                                  every roll call vote in Congress since the late 1800s. When
Exhibit 5                                                                                         they quantify the degree of divergence, they find that today
Change in US Structural Budget                                                                    we're at the highest degree of polarization ever seen in the
  2.5                                                                                             House and very close to it in the Senate. I think that reflects
        Percentage Points of Potential GDP
    2                                                                                             the very difficult challenges facing our legislators today and
  1.5                                                                                             their inability to come to grips with those challenges.
                                        Fiscal Restraint (+)
  0.5                                                                                             Exhibit 6
                                                                                                  Political Polarization is High – and Rising!
   -1                                                                                              1.0
                                                                                                         Distance Between the Parties
                                        Fiscal Stimulus (-)
   -2                                                                                              0.9

   -3                                                                                              0.8                                          Higher Polarization

                                                                                                   0.7                                  House
        Fiscal Years
        80   82    84   86   88   90   92    94    96     98   00   02   04   06   08   10   12    0.6                       Senate

Source: Congressional Budget Office (CBO)

I think the White House supports an extension of the expiring                                      0.4
stimulus. I think many in Congress support that as well. But
the debt ceiling debate is so bogged down in trying to reach a                                     0.3
                                                                                                      1885            1910              1935                1960         1985             2010
compromise that avoids default that this has gotten lost in the
shuffle. I think the White House will try to refocus on it shortly                                Note: This measure of political polarization is derived from analysis of the voting patterns of
                                                                                                  Congress and is based on the relative divergence in the average positions of Democratic and
after the debt ceiling is resolved. But perhaps the waters have                                   Republican legislators.
                                                                                                  Source: “Polarized America” by McCarty, Poole and Rosenthal
been so muddied that it will be difficult to actually enact an
extension of expiring stimulus measures.

So we could be facing an undesirable tightening of fiscal
policy in the short term. And I think all of this gets back to the
fact that political polarization is so high. Exhibit 6 is an


July 28, 2011
U.S. Debt Ceiling: Next Steps

Speaker: Arnaud Marès
I will follow up on David's remarks with a few observations         But there is considerable and possibly irreconcilable
about the risk of a downgrade of the rating of the US               disagreement on how to achieve that goal. So it would not be
government and the extent to which it matters. The first point      absurd for rating agencies to do for the US exactly what they
is that in the event that the debt ceiling is not raised in time,   did for the UK at the time, which is to wait until the election to
one should indeed expect the rating to be downgraded.               see whether a consistent majority emerges between the
                                                                    executive and legislative branches of government.
In that case the effects would be quite long-lasting, as it would
testify to the institutional weaknesses of a decision-making        The other arguments for rating agencies not to take a hasty
process that no longer fully protects the property rights of        decision on the rating of the US government are more
creditors. That is not what we expect to happen. If we              technical or even existential in nature. These have to do with
assume that this event remains very unlikely, then the much         the systemic relevance of the US Treasury market for the
more interesting question is whether rating agencies will           rating universe. The first argument here is that downgrading
downgrade the US government even if the debt ceiling is             the US government will attract much more attention and
raised.                                                             scrutiny than the downgrade of a government such as Ireland.
                                                                    In this context it would make sense for rating agencies to have
The dominant view in the market at the moment seems to be           a very robust and transparent framework to explain what
that this is almost certain. On our side, we believe that the       exactly marks the difference between a AAA and a AA
probability of the downgrade is real, but is significantly less     government before they take action.
than anticipated by the market. Why do we hold this view?
First, because the warnings of rating agencies came directly        We note that so far only Moody's has published a transparent
as a consequence of the deadlock on the deficit issue.              explanation of that point, and Moody's has had a
                                                                    comparatively moderate stance on the risk of a US
The urgency to act on their side came from the fact that they       downgrade. The second of these arguments is that
could not possibly afford to have been silent in the event,         downgrading the US raises fundamental questions as to what
however unlikely, that a credit event actually took place. So if    a AAA rating actually means. If the US is downgraded, it is
the question of the debt ceiling goes away, then the urgency        quite difficult to imagine that there will remain as many AAA
for them to act in the near term becomes much less. In that         issuers across other classes as there are now.
situation, the US government would once again become a
government that is not exposed to near-term liquidity risk, but     If the US is no longer AAA it becomes less credible to think
still faces very considerable fiscal challenges.                    that the governments of a number of European countries, or
                                                                    supranational institutions, or various private firms remain AAA
What would drive the determination of the rating in that            for a very long time. So the question that this raises for rating
situation is the likelihood that fiscal consolidation takes place   agencies is what a AAA rating actually means.
not in the very near term, but gradually over time. In this
context, the argument for an immediate downgrade has been           Should it be seen as a relative measure of creditworthiness,
developed by Standard & Poor’s explicitly as a low level of         by which I mean the most solid credit around, or must it be
confidence that the current political configuration can deliver     interpreted as an absolute measure of creditworthiness,
the medium-term adjustment plan that is required.                   meaning the credit of an issuer than cannot ever default?
                                                                    Prior to taking an action that would effectively impact the
Now, this is arguably a valid argument. But there is a counter-     meaning of ratings, we think it would make sense for rating
argument, which is that it is actually not the current political    agencies to have prepared the ground, which I don't think they
configuration that would matter, but that which will emerge         have really fully done at the moment.
from the election next year. From this perspective the
situation of the US is very similar to that of the United           So for these reasons we think that if the debt ceiling is raised,
Kingdom 18 months ago, when rating agencies underlined              which is our assumption, then it is not all that likely, or not as
that the AAA rating of the government was vulnerable, but did       likely as the market expects, that the US government would
not downgrade it.                                                   get downgraded in the very near term, meaning the next three
                                                                    months. What we would expect, however, is that rating
Similar to the UK, there is no disagreement in the US on the        agencies assign a negative outlook to the US rating to reflect
need for fiscal consolidation or the extent of what is required.    the fiscal dynamics that David presented earlier.


July 28, 2011
U.S. Debt Ceiling: Next Steps

If we are wrong, one possibility is that only one rating agency,   If you look at it this way, a downgrade from AAA to AA actually
namely Standard & Poor's, actually downgrades the                  means that there has been an intensification of the inherent
government. But what if we are completely wrong? Then the          conflict between the creditors of government and other
next question becomes how much does it really matter and           stakeholders of government (taxpayers, users of public
what are the implications? In the event that the US                services, beneficiaries of public expenditure) over the limited
government is downgraded, we suspect that the implications         resources available.
may be slightly more muted than generally expected for the
following reasons.                                                 Therefore, a downgrade would mean that it is marginally more
                                                                   likely that this conflict be resolved in a way that is detrimental
The first one is that a downgrade of the US government would       to creditors. But again, that does not necessarily mean a
in our view not cause that many investors to dispose of their      meaningfully higher risk of default. You also have to keep in
Treasuries. We think it would accelerate the ongoing trend         mind that there are other ways to inflict losses on creditors
towards less reliance on ratings in regulation and in              that are arguably less disruptive than default.
investment mandates, or other contractual arrangements in
the market. So the effect would be more on the use of ratings      We have published over the past year quite a lot of research
than on the market itself.                                         on these alternatives, but they include, for instance, regulatory
                                                                   distortion of financial returns and, of course, inflation. So
Second, and this might sound paradoxical, a downgrade of           paradoxically, if the US rating were to be downgraded, we
the US government from AAA to AA levels would not                  would expect that the main effect is to strengthen expectations
necessarily result in a significant market reassessment of the     that the endgame of the global sovereign debt crisis does not
risk of default. To understand that you have to remember that      take the form of default, but rather of widespread
at both the AAA and the AA level, a government is not              monetization of the debt and eventually inflation.
expected to default at any horizon.


July 28, 2011
U.S. Debt Ceiling: Next Steps

Speaker: Betsy Graseck
For the banks we consider several primary impacts: first,                                                                                                      Clearly, the banks are most exposed to the agency RMBS.
higher liquidity; second, impact to book value; and third, bank                                                                                                Exhibit 2 shows in rank order the impact of a one percentage
funding.                                                                                                                                                       point change in RMBS and Treasuries as a percentage of
                                                                                                                                                               book value for our large-cap banks. So if we have a one
I'll start with higher liquidity. Uncertainty around the debt                                                                                                  percent change in the value of Treasuries and agency RMBS,
ceiling, the risk of downgrade, and risk of default, even if you                                                                                               what is the impact on the book value of each of these
assign the probability of zero, is driving higher liquidity. Bank                                                                                              institutions? The banks at the high end of the range have a
managements need to have contingency plans in place even                                                                                                       significant amount of securities on their balance sheet.
for the most disruptive outcome, even if you do think that the
probability of that outcome is essentially zero.                                                                                                               Exhibit 2
                                                                                                                                                               Book Value Sensitivity: 1% change in value of
In fact, we have seen a significant increase in liquidity over the                                                                                             Treasury + agency debt/agency MBS
past few weeks, looking at the H8 data that comes out weekly.                                                                                                     2.5%
This seemed to start in mid-June. Maybe part of this had to
do with what's going on in Europe, but it looks to us like there                                                                                                           2.0%
are concerns over the debt ceiling as well. Exhibit 1 shows                                                                                                                        1.8%
what the year-on-year growth in liquidity has been doing
relative to the increase in Google searches for “debt ceiling” .                                                                                                  1.5%                    1.4%
Exhibit 1                                                                                                                                                                                                      1.1%

Debt Ceiling Concerns Appear to Have Increased                                                                                                                    1.0%
                                                                                                                                                                                                                      1.0% 0.9%
                                                                                                                                                                                                                                     0.8% 0.8%
Liquidity (in addition to concerns from Europe)                                                                                                                                                                                                   0.6% 0.6%
                                                                                                                                                                                                                                                               0.6% 0.6%
                                                   Core Deposit Growth, % y/y
                                                                                                                                                                  0.0%                                                 BK










                                                                                                                                                               Source: Company data, Morgan Stanley Research. For important disclosures regarding
                                                                                                                                                               covered companies that are the subject of this screen, please see the Morgan Stanley
   7.0%                                                                                                                                                        Research Disclosure Website at

   6.0%                                                                                                                                                        There's been obviously a lot of debate over whether or not
                                                                                                                                                               Treasuries would potentially rally on this news. I'm not the
   5.0%                                                                                                                                                        expert there, but I show the data so that you can make your












                                                                                                                                                               own assessments as to how the book values would be
     Core Deposit Growth (left)
     Internet Searches ''Debt Ceiling'' (scale not shown)                                                                                                      We anticipate that in any downgrade or even uncertainty
Source: Federal Reserve H8 Report, Google Trends, Morgan Stanley Research.                                                                                     period that investors will look towards the higher-quality
                                                                                                                                                               names and those that have the least amount of exposure to
The impact of higher liquidity is lower net interest margins as                                                                                                the securities that will likely be disrupted.
we move through 3Q11. The longer it takes to resolve the
debt ceiling and spending issues, the more pressure on net                                                                                                     Finally, on bank funding, I've spoken with my colleague Greg
interest margins as cash balances grow. The greatest impact                                                                                                    Gore, our credit desk analyst in fixed income, on this topic.
is on money center and trust banks.                                                                                                                            Bank funding is clearly a function of a variety of different
                                                                                                                                                               inputs. You've got inflation risk, sovereign credit risk, real
Next is the impact on book values, which is a function of how                                                                                                  rates. You've got Libor swap spreads, company credit risk
this gets resolved in the fixed income markets. For example,                                                                                                   and the cash CDS basis.
what's the impact on Treasuries, RMBS, corporate credit risk,


July 28, 2011
U.S. Debt Ceiling: Next Steps

To the degree that any of these inputs change as a result of              Longer term, I think the question is really about the outlook for
the debt ceiling debate, probability of downgrade, etc., that will        the economy and what happens to credit quality. Banks’
flow through into bank funding. Recently we have not seen                 specific risk is more likely to be a function of that outlook than
much change in bank funding. However, with the rising                     any of the near-term debates we're having right now.
uncertainties, liquidity is increasing and that gets us back to
our first point on looking for higher levels of liquidity in bank
balance sheets during this period.


Question                 How does the outlook for the economy change based on various scenarios that you're anticipating with
                         regard to the debt ceiling debate and the potential solutions around the fiscal question.

David Greenlaw           I'm excluding the impact of a default on interest or principle because that is not going to happen. So what is
                         the economic impact of the policy measures that will accompany the hike in the debt ceiling? There's
                         uncertainty surrounding the prospects for expiring tax cuts in 2011 and in 2012. I don't think that any of the
                         spending cut proposals that have been floated will have a meaningful impact on fiscal policy in the very near
                         term. These are ten-year spending cuts and they're heavily back loaded. A lot of them involve declines in
                         spending that were already assumed to occur such as in defense. So that is a source of some uncertainty
                         and depends on the outcome of the stimulus measures that will expire.

                         Another issue is the general uncertainty and the impact on business and consumer behavior. And that's
                         becoming an increasingly important issue. There have been stories in the press about businesses that were
                         going pretty well that are hesitant to add labor or invest in new capital because they’re concerned about the
                         developments in Washington. If this drags on for very long you will see more of a headwind for the real

                         The other kind of market impact issue is the effect of a downgrade. As Arnaud said, it's unlikely that S&P
                         pulls the trigger, but there is a possibility of a downgrade. And there's a lot of debate in the Treasury market
                         about the impact of that sort of outcome. Many investors believe that while there might be a short-term
                         headline effect that pushes yields higher, the more intermediate to longer run impact would be positive for
                         Treasuries and you'd see yields decline. That's because there would be concern about the impact on the
                         economy, the impact on consumer sentiment, business sentiment, even some portfolio repositioning into
                         Treasuries because of downgrades to other sectors.

                         So the direct market impact is unclear, but I wouldn't be surprised to see fears of a weaker economy and
                         even some buying of Treasuries from portfolios that have to raise their credit quality because everything's
                         getting downgraded.

Question                 Give us a sense of how you’re thinking about the base, bear, and bull cases for the fiscal outlook and the
                         impact on GDP outlook?

David Greenlaw           If the stimulus measures that are in place now – in particular the payroll tax cut – expire, you'd be looking at
                         about a one and a half percentage point contractionary fiscal policy next year, which could cut almost a point
                         from GDP growth, all else being the same. That is a concern, and I think the leadership in Washington is
                         focused on that. As part of the grand compromises that have been discussed in recent weeks, this was
                         going to be a component. But now the waters may have become so muddy that you can't include this in a
                         debt ceiling hike and you're going to have to deal with it later. That leaves you in an environment of some
                         uncertainty and negatively impacts the economy. My assumption is that the stimulus measures will get
                         extended, but I'm much less certain of that outcome than I was a few weeks ago.


July 28, 2011
U.S. Debt Ceiling: Next Steps

Question                 Can you talk about why you see a low probability of an S&P downgrade when they've asked for $4.4 trillion in
                         cuts over ten years and it looks as if we might not see that in the near term?

Arnaud Marès             When we talk about low probability, we should qualify this. We think the market expects a downgrade to be
                         almost certain, whereas we think the probability is much less than that. It is certainly not zero. What
                         happens once we have an agreement, whatever the nature of the agreement, remember that this is a plan
                         that will be implemented over the course of a decade.

                         The life expectancy of the current political configuration is limited by the coming elections in 2012. Therefore
                         the question, as it was in the case of the UK, is should a rating decision be made for a ten-year plan based
                         on the action of a government and Congress that actually won't be there to implement it, or should one look
                         at the likely action that will take place after the election?

                         There is no fundamental disagreement on the need to reduce the deficit. There is a very significant
                         disagreement on the means to do so. This decision will be presented to the American people in the
                         elections. If the outcome of the election creates a political configuration that allows a plan to be put in place,
                         then that is a completely different setup from the one we have at the moment. So while the likelihood of a
                         downgrade is not zero, once the issue of the debt ceiling has gone, much of the debate will be refocused on
                         a more medium-term issue, and that reduces the likelihood of action.

David Greenlaw           Let me add one thing. I think that sovereign credit analysis is much more an art than a science, especially
                         when it comes to the developed markets. There are no hard and fast rules. But I think Arnaud has made a
                         powerful case for delaying a downgrade at this point. Also, I would point out that current law in the US is that
                         the Bush era tax cuts enacted in 2001 and 2003 expire at the end of 2012. If you allow those tax cuts to
                         expire, you raise about $4 trillion over the next ten years and the debt/GDP ratio holds at around 70% for that
                         period. So I'm not sure you can implement a downgrade at this point if you assume that current law holds.
                         As Arnaud said, the election will go a long way towards deciding the outcome here. But current law is the
                         expiration of the Bush tax cuts, which would leave you with a stable debt/GDP ratio for the next ten years.

Question                 What does a potential downgrade mean for the banks and what is the outlook for their funding, how does it
                         impact US financials?

Betsy Graseck            I think the most important thing is the inputs to the funding costs for the banks and some of the things that
                         David just mentioned. Number one is what happens to the base rate, what happens to US Treasuries.
                         There's an argument that Treasuries would rally. So if that were to occur, the other question is to what
                         degree does your outlook for the economy weaken enough to drive up idiosyncratic risk at the banks. In an
                         environment where Treasuries are stable, if the outlook for an economy slows down we would expect to see
                         some bank funding cost increase. To deal with that, you pre-fund, bring down some of your long-term debt,
                         which is running at a higher cost of funds than current long-term debt. So we do still feel there is an
                         opportunity for institutions to manage their funding efficiently.

Question                 What is the importance of August 2?

David Greenlaw           August 2nd was chosen for one reason, because the Social Security payments go out on August 3rd. And
                         Treasury Secretary Geithner had always, I think, planned to use the Social Security payments as his ace in
                         the hole. In other words he would force a compromise once there started to be fear that Social Security
                         checks would be delayed, and you'd have very significant public pressure to reach a compromise. If we get
                         towards August 2nd and there is no sign of a deal in place, the Treasury could decide to make those Social
                         Security payment in various ways.
                         The first significant interest payment is on August 15th. And presumably by our estimates they can actually
                         get through August 15th using the tools that they have already identified. But it becomes a little bit more
                         dicey at that point and they would probably have to implement other special measures, rely on the 14th
                         amendment, something along those lines to continue to make the payments. But I think they would make
                         those payments and then deal with the consequences later.


July 28, 2011
U.S. Debt Ceiling: Next Steps

Question                 How are you thinking about the yield curve performance given some of the questions that are out there.
                         Would institutions be forced to sell US government bonds due to a potential downgrade for regulatory
David Greenlaw           We do not think that there would be significant selling by Treasury market investors. Some very large real
                         money managers indicate that to the extent that there were documents in place that required investments in
                         AAA securities, those documents have been changed or are in the process of being changed. Most
                         documents do not specify AAA securities. They specify Treasuries or government guaranteed debt. So I
                         don't think there would be significant selling because there just aren't many requirements to hold AAA
                         The thing that concerns me the most would be just the headline impact on foreign investors. We saw some
                         of this during the experience with the GSEs in 2008. There was never any risk that the GSEs would default
                         on their debt, but foreign investors sold their GSE holdings during those periods because they were under a
                         lot of pressure. We obviously have a very heavy concentration of foreign investor holdings of Treasury debt.
                         Actually, the risk of an upside market correction is perhaps more significant, tied to fears about the impact on
                         the economy. Some funds will have to raise their credit quality if Treasuries get downgraded and actually buy
                         more Treasuries.

Question                 What would be the degree of impact of a downgrade on the repo market?

David Greenlaw           We don't think there would be any meaningful impact there. If we somehow get some extreme volatility in
                         the Treasury market and bid/ask spreads were to widen significantly, you'd have some problems for repo.
                         But I think the repo market is pretty well prepared for this event. All of the systems have been tested.

Question                 What about the priority of Treasury payments, and where do the GSEs fit in to all this?

David Greenlaw           The prioritization issue has gotten a lot of attention and some view it as a viable solution to the debt ceiling
                         problem, as the Treasury could prioritize certain payments and avoid default on interest or principle. I just
                         don't see that as a viable alternative at this point. It's true that the Treasury's debt service is much, much
                         lower than its overall receipts. But that is not true every day. There are only a couple of days when the
                         Treasury makes debt service payments, and there are only a couple of days when it has other huge payment
                         obligations like Social Security. And on those days their income does not come close to matching their
                         So you could prioritize payments only if you start well ahead of the point at which some of those big
                         payments are due. And the Treasury shows no inclination to do so, and it's not even clear if it can legally do
                         that. So I just don't buy into the notion that prioritization is a viable option. If the stalemate continues, the
                         Treasury would continue to meet their obligations, but they would use some other mechanism.
                         With regard to the GSEs, there are many different entities that rely on the Treasury credit, such as the GSEs,
                         other government-sponsored agencies, some municipal bonds that have a Treasury guarantee component,
                         the pre-refunded municipal bonds. All of those securities are subject to the rating of the Treasury, and to the
                         extent that the rating of the Treasury changes, all of those securities are affected. But much like what we're
                         likely to see in the Treasury market, I'm not sure there would be much of a market impact.

Question                 Is monetization — i.e., inflation, easing, et cetera — a way of solving this?

David Greenlaw           It is not a way of solving this particular problem. Ultimately a country like the US, a sovereign that has its
                         own currency, should never default. The Fed is the lender of last resort, and the Treasury can meet its
                         obligations in several ways. They can tax, borrow, or print. So in theory there is absolutely no risk of default.
                         However, it is obviously a very poor outcome when you get to the point that the only way you can finance
                         yourself is for the central bank to print. Some countries have gone that route, and it always ends in tears.
                         But in theory there is no risk of a US default at any point in the future because they can tax, they can borrow
                         or they can print.


July 28, 2011
U.S. Debt Ceiling: Next Steps

Arnaud Marès             I would add that you do not need a lot of inflation to inflate your way out of debt. It is already happening in a
                         number of countries. The key parameter is the difference between the cost of servicing the debt, the interest
                         rate that you pay on operating your debt, and the nominal rate of growth of the economy.

Question                 Can you comment on the banks’ appetite for Treasuries going forward?

Betsy Graseck            The Basel III negotiations are considering the possibility for a requirement to hold liquid assets that would
                         drive more Treasury purchases potentially. It's still under debate. So I think it's too soon to suggest that you
                         will see banks looking to increase Treasuries due to Basel III.


July 28, 2011
U.S. Debt Ceiling: Next Steps

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July 28, 2011
U.S. Debt Ceiling: Next Steps

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U.S. Debt Ceiling: Next Steps

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