Presentation to the Treasury 

Borrowing Advisory Committee 

January 31, 2006
Question 1: Bills/Coupon Composition

We seek to develop guidelines for the appropriate 

composition of Treasury’s debt portfolio based on the share 

of the portfolio devoted to bills relative to coupon 

securities. We would like the Committee’s views on charts 

that we present and Committee suggestions on how to 

further develop guidelines on portfolio composition.
Characteristics of Bill Financing

• Flexibility: Frequency of issuance and 

maturity creates flexibility for uncertain 

borrowing needs

• Capacity: The bill market is accustomed to 

volatility of issuance and can absorb seasonal 

and transient supply shocks with little price 

distortion

• Cost: Given the term structure of rates, bill 

financing is cheaper over time 
Characteristics of Coupon Financing

• Lower Rate Volatility: Coupon financing is subject 

to lower interest cost volatility

• Reduced rollover risk: – Longer portfolio maturity 

decreases risk of not being able to rollover debt at 

critical times 

• Reduced Operational Risk: - Longer maturities 

require fewer auctions

• Expanded Investor Base: Many investors desire 

longer-dated debt instruments -- expanding investor 

base attracts more investors to Treasury securities, 

reducing borrowing costs.
Portfolio Considerations

• Interest cost over time

• Various risks (Operational, Cost Volatility, 

Rollover)

• Flexibility to respond to uncertainty in 

borrowing needs

• Capacity – Constraints on issue sizes and 

changes in issue sizes for bills and coupons

• Providing liquidity and Benchmark status

• Expanding the investor base
18%

20%

22%

24%

26%

28%

30%

32%

34%

36%

19771978197919801981198219831984198519861987198819891990199119921993199419951996199719981999200020012002200320042005

Fiscal Year

Percent

Bills as a% of Tot Outs. Bills as a% of Nom Outs. Average(tot out)

Average = 26.1 percent
Debt Distribution

Bills vs Coupons

Bills, 23%

Coupons, 

77%

Bill Portfolio

4-week bill, 

8%

13-week bill, 

33% 26-week bill, 

59%

Nominal vs Inflation Coupons

Nominal 

Coupons, 89%

Inflation 

Coupons, 11%

Maturity

Less than 1 

year, 23%

2yr-10yr, 40%

10 years or 

greater, 36%
Historically, bills carry lower interest rates on average, but higher interes

cost volatility

1962-Present

1962-Present Std Avg # Current

Avg Cost Dev Auctions # 

Percent Percent 1990-Present Auctions

Bills 134 177

 3 month 5.88 2.91

 1 year 6.29 2.93

Coupons 3 4 4 4

 3 year 6.71 2.75

 5 year 6.93 2.64

 10 year 7.15 2.53

 30 year* 7.52 2.40

Total 171 221

* concatenated series using 20 year rate from 1962 to 1977 and 

 30 year rate from 1977 to 2002
T

Bill Issuance is Used First to Address Changes in the Deficit

(150,000)

(100,000)

(50,000)

-

50,000

100,000

150,000

200,000

196219651968197119741977198019831986198919921995199820012004

Year

Change in net T-Bills ($ millions)

(500,000)

(400,000)

(300,000)

(200,000)

(100,000)

-

100,000

200,000

300,000

Change in Net Bills (in millions)(r ) Annual Budget Deficit (in millions) (L)

Correlations

Deficit/Change in bills 0.309

Deficit(t-1)/change in bills 0.481
DEBT MATURITY MEASURES

20

30

40

50

60

70

80

90

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 201

months

months

Average Maturity of Issuance

Average Maturity 

53

As of December 31, 2005

36

Projected

Projections are based on current OMB MSR budget estimates, except for Treasury's internal FY 2006 estimate. Future residual financing 

needs are spread proportionally across auctioned securities to maintain constant maturity of issuance.
Question 2: 30-Year Bond

We would like the Committee’s views on resumed issuance 

of the 30-year bond; initial sizes, coupon cycles for the 

STRIPS market, and the potential consequences of moving 

to quarterly while maintaining the same annual issuance in 

2007. 
Treasury Bonds Held in Stripped Form

percent of total privately held bonds outstanding

(as of 12/31/05)

37%

63%

Privately Held Unstripped

Portion Held in Stripped Form

Source: US Treasury Bureau of the Public Debt

Feb/Aug

maturities

16%

May/Nov

maturities

21%

May/Nov

maturities

22%

Feb/Aug

maturities

41%
y g y pp

(as of 12/31/05)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Nov-14

May-15

Nov-15

May-16

Nov-16

May-17

Nov-17

May-18

Nov-18

May-19

Nov-19

May-20

Nov-20

May-21

Nov-21

May-22

Nov-22

May-23

Nov-23

May-24

Nov-24

May-25

Nov-25

May-26

Nov-26

May-27

Nov-27

May-28

Nov-28

May-29

Nov-29

May-30

Nov-30

percent

Source: US Treasury Bureau of Public Debt

May/Nov maturities

Feb/Aug maturities

Total percent of privately held bonds outstanding stripped = 37%
Treasury Bonds STRIPS

Bonds with maturities from 2/15/26 - 2/15/31, as of 12/31/05

0

2

4

6

8

10

12

14

16

18

20

Feb-26

May-26

Aug-26Nov-26

Feb-27

May-27

Aug-27Nov-27

Feb-28

May-28

Aug-28Nov-28

Feb-29

May-29

Aug-29Nov-29

Feb-30

May-30

Aug-30Nov-30

Feb-31

$ billions

unstripped

held in stripped form

Source: US Treasury Bureau of the Public Debt
Question 3: Shape of the Yield Curve

The recent flattening of the yield curve has led to 

questions about the relationship between the shape of the 

yield curve and the outlook for financial markets. We 

would like the Committee’s views on the relevance of 

curve shape, at current levels, on the financial markets 

and institutions. 
Presentation to the U.S. Treasury

and the Treasury Borrowing

Advisory Committee

January 31, 2006
TBAC

A Flat Yield Curve and its Implicatio

Financial Markets and Institutions

January 31st, 2006
GDP and the Housin
We Think the General Economic Climate in 2006 Will Be Generally 

and that the Consumer Should Remain in Decent Financial Shape...

GD

Real Disposable Income (%

Household Net Worth ($tr) Unemployment Rate (%

___________________________Source: Commerce Dept, BLS, Lehman Brothers.

0

10203040506070

Mar-90 Mar-93 Mar-96 Mar-99 Mar-02 Mar-05

Forecast

-2

02468

Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan

% 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06 2005 2006 2007Real GDP 3.8 3.3 4.1 1.1 4.5 3.2 2.8 2.5 3.5 3.2 3.0 Private consumption 3.5 3.4 4.1 1.1 3.5 2.7 2.5 2.2 3.6 2.8 2.6 Government expenditure 1.9 2.5 2.9 -2.4 5.5 3.5 3.5 3.2 1.7 2.7 3.0 Non res fixed invest 5.7 8.8 8.4 2.8 9.8 9.0 9.0 9.0 8.5 7.9 9.8 Residential fixed invest 9.5 10.8 7.3 3.5 -5.0 -5.0 -5.0 -5.0 7.2 -1.0 -5.0 Exports 7.5 10.7 2.5 2.4 7.0 7.0 6.8 6.4 6.7 5.7 8.4 Imports 7.4 -0.2 2.4 9.1 6.0 5.5 5.0 5.0 6.2 5.4 6.3Contributions to GDP: Domestic final sales 3.9 4.4 4.7 0.8 4.0 3.1 3.0 2.7 4.1 3.1 3.2 Inventories 0.3 -2.2 -0.4 1.4 0.8 0.3 -0.1 -0.1 -0.3 0.3 0.0 Net trade -0.4 1.1 -0.1 -1.2 -0.3 -0.2 -0.1 -0.2 -0.3 -0.3 -0.1Unemployment rate 5.2 5.1 5.0 4.9 4.9 4.8 4.9 5.0 5.1 4.9 5.0Non-farm payrolls, 000 182 198 147 146 200 170 150 130 168 163 130Consumer prices 3.0 2.9 3.8 3.7 3.5 3.1 2.5 2.3 3.4 2.9 2.3

Core CPI 2.3 2.2 2.1 2.1 2.1 2.2 2.4 2.5 2.2 2.3 2.5

Core PCEdeflator 2.2 2.0 1.9 1.9 2.0 2.1 2.2 2.3 2.0 2.2 2.2

United States

3.5

4

4.5

5

5.5

6

6.5

Mar-95 Sep-96 Mar-98 Sep-99 Mar-01 Sep-02 M

Full Emp

Unemployment Rate

1
The Historic Signals of Economic Growth, Such as the Shape of the Curve and Mo

Are Much Less Robust Barometers of Future Economic Performance Today... ThRamifications of a Flat Curve and the Level of Rates for the Consumer, as Well as Financial Markets, Are Important...

GD

Nominal GDP and Money S

Probability of a Recession* GDP – Curve Regre

___________________________Source: US Treasury, Lehman Brothers. *Using a Probit Model to Calculate the 1 year future probability of a Recession using the 3 month bills to 10 year treasury spread as the independ

TSY 10yr – Fed Funds Spread

02468

10121416

Mar-60 May-69 Jul-78 Sep-87 

% y-o-y

GDP (nominal) 

-6%-4%-2%

0%2%4%6%

Mar-66 Mar-75 Mar-84 Mar-93 Mar-02

0%

10%20%30%40%50%60%70%80%90%

1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004

2

1964:Q1-1989:Q4 

TSY Curve

Corporate 

Curve 

Constant 2.13 2.42 p value [0.000] [0.000] TSY Spread (t-4) 1.15 p value [0.000] Corporate Spread (t-4) 0.81 p value [0.000] R-Squared 0.312 0.337 

Note: p-values in brackets are calculated using Newey-West standarGDP % y-o-y; Source: Lehman Brothers
60

708090

100110120

Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

Coming into 2006, Consumer Confidence and Disposable Income (and/or Are in Solid Shape... Yet, This Could Very Well Deteriorate over the ComQuarters...

GD

But Households Have Come to R

on Home Equity Extractio

Equity Extraction Depends on Two Factors: Residual Effects:

___________________________Source: Conference Board, University of Michigan and Federal Reserve.

Household Moods Remain Cautious –

But Improving...

 Interest rates

– We expect mortgage rates to remain well below 6.50%– Homeowners will have little additional rate incentive 

to refinance

 Price appreciation

– We expect home price appreciation to cool but not collapse

– Some regional markets may be overvalued, but they account 

for 30% of the aggregate housing stock

 Households don’t typically spend all funds e

– About 50% is used to increase savings an– Which suggests that there could be as mu

over from 2005 available for spending or 

Conf Board

U/M

Consumer Confidence (Dec2003 = 100)

-1.0-0.5

0.00.51.01.52.0

1991 1993 1995 1997 1999 2001 2

% disp income, rhs

GDP contrib, lhs

GDP contrib, %

Home Equity Extraction

3
The Monthly Payment for the Populace at Large Is on the Upswing, Largely d

Cost of Home-Ownership and the Nature of How That Ownership Has Been F

GD

___________________________Source: Federal Reserve

Homeowners – Consumer Homeowners – Mortga

Homeowners – Total Renters Total (Homeown

4.0%4.5%5.0%5.5%6.0%6.5%7.0%

Mar-80

Mar-82

Mar-84

Mar-86

Mar-88

Mar-90

Mar-92

Mar-94

Mar-96

Mar-98

Mar-00

Mar-02

Mar-04

8.0%8.5%9.0%9.5%

10.0%10.5%11.0%

Mar-80

Mar-82

Mar-84

Mar-86

Mar-88

Mar-90

Mar-92

Mar-94

Mar-96

13.0%13.5%14.0%14.5%15.0%15.5%16.0%16.5%17.0%

Mar-80

Mar-82

Mar-84

Mar-86

Mar-88

Mar-90

Mar-92

Mar-94

Mar-96

Mar-98

Mar-00

Mar-02

Mar-04

21%23%25%27%29%31%33%

Mar-80

Mar-82

Mar-84

Mar-86

Mar-88

Mar-90

Mar-92

Mar-94

Mar-96

Mar-98

Mar-00

Mar-02

Mar-04

15.0%15.5%16.0%16.5%17.0%17.5%18.0%18.5%19.0%

Mar-80

Mar-82

Mar-84

Mar-86

Mar-88

Mar-90

Mar-92

4

Financial Obligation Ratio – Debt Payments as a Percentage of Disposable Incom
Simultaneously But Equally As Important, Healthcare & Energy Expenses Are 

While the Middle Class Consumer Continues to Utilize Housing Gains As ThSavings Vehicle...

GD

Net Worth to Disposable Incom

Fuel, Gas, & Electricity Expenses 

as a Percentage of US Consumer Wages

For Most Consumers, Their Home 

Important Asset

Medical Care Expenditures as a Share of Disposable 

Income Continues to Rise

%

Medical Care/Disposable Income

0%2%4%6%8%

10%12%14%16%18%

Mar-47 Mar-51 Mar-55 Mar-59 Mar-63 Mar-67 Mar-71 Mar-75 Mar-79 Mar-83 Mar-87 Mar-91 Mar-95 Mar-99 Mar-03

4.004.505.005.506.006.50

Mar-52 Mar-56 Mar-60 Mar-64 Mar-68 Mar-72 Mar-76 Mar-80 Mar-84 Mar-88 Mar

Net Worth to Disposable Income 

Ratio of Net Worth to Income 

7%8%9%

10%11%12%13%14%15%16%

1980-I

1981-I

1982-I

1983-I

1984-I

1985-I

1986-I

1987-I

1988-I

1989-I

1990-I

1991-I

1992-I

1993-I

1994-I

1995-I

1996-I

1997-I

1998-I

1999-I

2000-I

2001-I

2002-I

2003-I

2004-I

2005-I2

4681012141618

Energy Expenses as a % of US Wages (LHS) 10-yr TSY Yield (RHS)

___________________________Source: Lehman Brothers, Federal Reserve, BEA and FactSet. 

0%

20%40%60%80%

0 10 20 30 40 50 60 

Wealth Percentile

Stock Share 1989 

Housing Share 1989 

Portion of Household Assets (%)

5
The Engine of Growth

Home Wealth Extraction Has Been the Primary Engine Allowing Consumers to Expa

Capacity ... The Shape of the Curve and Level of Rates Have Had a Profound Imp

Phenomenon...

GD

___________________________Shows equity extracted through cash-out refinancings and existing home sales. Source: Lehman Brothers, Federal Reserve, MBA.

Share of ARM’s Has Grown to 50% of All Originations The HEL Market Has Grown 

Gross Equity Extraction from the US Mortgage Market – Federal Reserve Estimate 

0

200400600800

1,000

2000 2001 2002 2003 

Fed Reserve Estimate ($bn)

21% 21%

25%

33%

39%

43%

46% 47% 46% 48%

0

96

192288384480

1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05

0%12%24%36%48%60%

ARM O riginations ($bn) % of All Mortgage O riginations (Right)

0

1530456075

1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04 1

HELs ($bn) % of Net Issuance in M

6
Payment Shocks Down the Road???

The Nature of the Curve over the Past Few Years Has Created a Dynamic Which Requires Either Groa Continued Robust Housing Market to Prevent a Payment-Increase Induced Spending Slowdown...Hof the Curve and Level of Rates, Will Be the Primary Driver of How This Plays Out over the Coming 

GD

Payment Shock on the PRIME ARM Universe at First Reset

Payment Shock on the NON-PRIME ARM Universe at First Reset

2008 204 93 37% 73% 

All ARMs IO/Neg-am

Payment Increase

2010 187 145 34% 94% 2009 514 368 36% 85% 

63%69%

IO Effect

35%36%

Rate Effect

2007 203 110

2006 100 39

Total Volume 

of Resets ($bn)

Horizon (months)

2008 31 12 44% 73% 

All ARMs IO/Neg-am

Payment Increase

2010 1 1 43% 60% 2009 8 5 46% 71% 

70%72%

IO Effect

41%41%

Rate Effect

2007 159 44

2006 309 62

Total Volume 

of Resets ($bn)

Horizon (months)

7

___________________________Payment Increase under Rate Effect captures payment jump due to a change in rates. IO/Neg-am effect captures payment jump due to expiry of IO period or teaser pEffect. Total payment increase is computed based on level-pay borrowers subject only to rate effect and IO/Neg-am borrowers subject to IO/Neg-am effect. Scaled up ARMs and $650bn of sub-prime ARMs from the ARM reset distribution in non-agency securitized universe as of 2Q05. Forward rates as on 11/21/05.
Is There an Exit Strategy? Yes...But It’s Very Optim

GD

 The primary conclusion from the previous page is that if rates moved along the forward curve and if the borrowers st

current mortgage, they would need to spend a significantly higher proportion of their income in servicing their mortgthe scenarios where this would be less of an issue are:

– Sharp Rally in Rates

– Offsets from Income Growth - This would call for rosy optimism. For instance, for ARMs resetting 2-3yrs out, 

growth of the order of 20-25% is required to offset payment shocks

– Keep Rolling it Over - The most plausible exit option is for the borrowers to keep rolling over their mortgage an

payment shocks through that process. There are quite a few stumbling blocks for this easy way out. First, short tehave already risen significantly over the past several months. The second stumbling block is willingness of lendeoffer IO/neg-am loans. If the IO/neg-am products are not available – say, due to a secular tightening in lending stof a softening in the housing market interest rates would need to rally by 150-200bp for borrowers to be able to romortgages painlessly

Scenarios That Bail Out Leveraged Borrowers Look Rather Optimistic

___________________________* In an optimistic scenario, the borrower can refi into an identical product. In a pessimistic scenario, the borrower may only refi into a level-pay ARM.B/E Income Growth is computed such that at time of reset, borrower has the same DTI as at origination.Required rally in mortgage rates is computed such that at the time of reset, the borrower refis and monthly payments are unchanged. The required rally is computed from the forward mort

type. With growth in income, the borrower is able to afford a higher monthly payment.As of end April 2005, mortgage rates 5 years forward are 100 bp above spot rates. 

48+ 516 54% 13% 9% 102 168 1 

37 – 48 325 42% 14% 9% 111 169 18 25 – 36 419 52% 21% 15% 117 185 24 13 – 24 182 53% 37% 24% 133 197 71 

0 – 12 324 36% 90% 36% 166 191 145 

($bn) (%) IO/Neg-am Total Optimistic Pessimistic Optimis

Horizon Resets Increase (annual) 0% Income Growth 4% I

Total ARM Payment B/E Income Growth Required Rate Rally to Refi with no P

8
Financial Ins
Insurance Companies...

Achieving Target Yield/Returns in a Low Yield, Flat Curve, Tight Credit Environment Has Become Very Difficult for Insurers...

___________________________1. All spreads are illustrative estimates. Investment Grade Corporates include both publics and privates. MBS spreads are OAS for generic pass-throughs. Actual commercial mortgag

depending on individual loan characteristics. Asset yields assume a mix of 5yr and 10 yr assets.

1.17%

3.59%4.76%1.75%1.00%0.25%2.10%0.90%

December 2003

10% Commercial Mortgage Loans 2.25% 10% ABS/CMBS 0.90% 7% Below Investment Grade Corporates 3.55% 60% Investment Grade Corporates 1.80% Asset Spreads (over UST)

De

Annuity Crediting Rate (5yr UST+25bps) 4.59%Net Spread 1.83%Asset Yield 6.42%13% MBS 0.55%

Fixed Annuity Analysis December 2001 (1)

9
10-Year U.S. Treasury and HG Index OAS

Interest Rates and Credit Spreads Pressure on Spread Income:Yield Compression Has Heightened Reinvestment Risk for the Life Industhe Industry’s Ability to Organically Grow Margins on Spread Products...___________________________Source: Lehman Brothers.

300400500600700800

1Q95 3Q95 1Q96 3Q96 1Q97 3Q97 1Q98 3Q98 1Q99 3Q99 1Q00 3Q00 1Q01 3Q01 1Q02 3Q02 1Q03 3Q03 1Q0

(bp)

10-Yr Treasury (bp) Credit Index OAS (bp)

10
Creating The Need to Take on Additional Risks to Offset This Phenomen

The Structured Markets Have Become Extremely Important to Insurance to Offset the Impact from the Yield Curve Dynamic of the Past Few Year Looking beyond the traditional cash bond market, insurance companies filed approximately 900 R

Synthetic Asset Transactions (RSATs) with the Securities Valuation Office (SVO) in 2005, a 175% 

years (RSATs reflect only US General Account transactions)

 In addition, participation in credit linked notes (CLN), which is not captured by RSAT filings, incr

insurance companies were among the top investors in CLNs with synthetic CDO exposures over th

___________________________Source: Securities Valuation Office.

Cumulative RSATs Filed with the NAIC

0

100200300400500600700800900

2001 2002 2003 2004 

RSATs Filed with the NAIC

11
Asset Quality Shift:

While Reducing Exposure to High-Yield Assets Post 2002 (to address Rating Concerns)Increased Exposure to High Quality Structured Assets and have, at the margin, added CoEnhance Yield...

64.3% 61.7% 62.9% 62.7% 

28.3% 30.8% 28.6% 29.6% 

7.4% 7.5% 8.5% 7.7% 

0%

20%40%60%80%

100%

2000 2001 2002 2003 

A or Higher BBB Below-Investment-Gr

U.S. Life Industry Asset Mix

___________________________Source: Highline Data.

12
The Nature of Annuity Sales Has Changed Alongside a Low and Flat Yie

Environment... It Has Forced Demand into Riskier Products in an AttempAchieve Decent Returns... This Trend Will Continue into ’06...

Annuity Sales vs. Treasury Curve

___________________________Source: LIMRA, Bloomberg.

0

20406080

100120140

2001 2002 2003 2004 Q3 20

($ bn)

Fixed Annuity (LHS) Equity Index Annuity (LHS) Variable Annuity (LHS) 2s-10s Spread (RHS

13
Effect of Interest Rates and the Flattening of the Yiel

on Life Insurance Companies Low-interest rates have been a negative for the industry...

– Given that reinvestment yields have forced down spreads on fixed-rate products

– The industry has responded by lowering crediting rates on its products to partially offset the dec

portfolio yield

– Given that rates have fallen to historical lows in the last few years, the industry was forced to se

permission to drop minimum policy crediting rates below 2%, from the 3.5%-4.0% range

– This has enabled the industry to mitigate what would have been a very material blow to ROE in 

several years

 Flattening Yield Curve: also a negative...

– By definition, a flattening yield curve is a negative for life insurance companies as the long dur

whole life insurance and fixed annuity sales are be disintermediated by higher-return/short-dura

products like bank CD’s

– In the current low nominal yield environment, the flattening of the curve, through higher short t

compounds the negative sales picture for traditional life and fixed annuity products which offer 

incremental yield play compared with short-duration contracts

– That said, we still believe that the low yield environment has been more of a negative for life co

recent quarters. Despite a positive sloping yield curve (until recently), fixed annuity sales have 

due to lower crediting rates

14
Effect of Interest Rates and Flattening of the Yield C

Life Insurance Companies (Cont’d) Earnings Impact: Lower sales and contracting product spreads negativ

earnings for several reasons...

– First, lower sales hurt GAAP earnings, given that GAAP accounting rule

insurers to amortize the expense of commissions and other costs associatwriting new policies. Hence, growth typically results in higher GAAP earperiod the new policy is produced (this is not the case for statutory accouwhere all costs are expensed up front)

– Second, contracting spreads are a more obvious negative as insurers endu

contraction in their portfolios. And while there is an ability to lower credpolicies, there are minimum crediting guarantees in most policies, which point limit the insurer’s ability to maintain spread margin in a falling rate 

These dynamics continue to be in place in 2006, perpetu

need to increase risk-tolerance in multiple spots...

15
The Banking System...

There Is Clearly a Profound Correlation over the Past 40 Years Between BEarnings (and Equity Performance) with the Shape of the Yield Curve...

US Bank Index Relative to the S&P 500 vs. Yield Curve, 1925 – Present

___________________________Note: Lighter-shaded bars indicate year when discount rate (1925-54) and fed funds target (1955-present) ended the year higher than where it began.Source: Lehman Brothers, Baseline, DRI, FactSet, Bloomberg, and Standard & Poor’s.

-80%-60%-40%-20%

0%

20%40%

1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 

5-yr/13-week Spread, righ

Relative Bank Performance, left

16
The Equity Market Seems to Accurately Reflect the Tangible Nature of NIM Performance in a Flat C

Environment... However, the Nature of the Banking System over the Past 5 to 10 Years Has Changed Correlation Should Still Hold, yet More Loosely Than in the Past... NIM’s Have Been Contracting, R

Curve Paradigm over Prior Years. More Performance Is Now Driven from Fee Income...

Net Interest Margin vs. 5-Year/13-Week Interest Spread

Net Interest Margin, 1934 – 1H05

___________________________Source: Company reports, Lehman Brothers, FDIC, Federal Reserve and Baseline.

3.0%3.4%3.8%4.2%4.6%

1Q96 4Q96 3Q97 2Q98 1Q99 4Q99 3Q00 2Q01 1Q02 4Q02 3Q03 2Q04 

Net Interest Margin

NIM 5-yr/13-wk Spread

0.0%1.0%2.0%3.0%4.0%5.0%

1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 

17
The Consolidation of the Banking Sector Has Clearly 

Primary Driver of This Evolutionary Change...

Top 25 Banks by Market Capitalization, 1990 and 2005

Rank Company Market Cap 

1 J.P. Morgan & Co. $8,238 

2 BankAmerica $5,654 

3 Bank One Corp. $4,408 

4 Citicorp $4,248 

5 Bankers Trust NY Corp. $3,510 

6 Wells Fargo $2,977 

7 First Wachovia $2,918 

8 SunTrust Banks $2,885 9 Security Pacific $2,572 

10 NBD Bancorp $2,407 

11 NCNB Corp. $2,353 

12 C&S/Sovran Corp. $2,106 

13 Norwest Corp. $2,100 14 PNC Financial Corp. $2,066 15 National City Corp. $1,878 16 CoreStates Financial $1,725 

17 Republic New York $1,703 

18 First Union $1,679 19 Manufactures Hanover $1,546 

20 First Interstate $1,461 

21 Chase Manhattan $1,383 

22 Fifth Third $1,300 23 The Bank of New York $1,231 24 U.S. Bancorp $1,222 

25 Fleet/Norstar Financial $1,212 

Average of Top 25 $2,591 17x Larger

1990 2005

Rank Company 

1 Citigroup 

2 Bank of America 3 JPMorgan Chase 4 Wells Fargo 5 Wachovia 6 U.S. Bancorp 7 SunTrust Banks 8 Bank of New York 9 BB&T Corporation 

10 Fifth Third Bancorp 11 National City 

12 State Street 13 PNC Financial 14 Regions Financial 15 Mellon Financial 16 KeyCorp 17 North Fork Bancorp 18 M&T Bank Corp 19 Northern Trust 20 Marshall & Ilsley 21 UnionBanCal 22 Comerica Inc 23 AmSouth Bancorp 24 Synovus Financial 25 Zions Bancorporation 

Average of Top 25 

___________________________Source: SNL, Reuters, Lehman Brothers

18
It Is Too Simplistic to State the Shape of the Curve/Level of Rates Has One Unique Impact on 

System... There are Dramatic Structural Differences Between the Different Types and Sizes o

For Integrated Providers and Fiduciary Banks, Fee Income Is a Large Part of the Fee Pool, WhFunding Is Critical for the Integrated Providers...

O perating Revenues

Loans

26.3%

Core Fee 

Inco me

43.2% IB Core

9.6%NIB Core

9.4%

Ot her

Trading / 4.7%

Gains

6.7%

Aggregate Bank Universe

The drive to continue to grow fee income sources and offset the higher costs of market funding 

environment, result in a need to take on greater risk, expand out the Business platform and a

___________________________

minimize costs... This is clearly taking place in the Banking System today...

Source: Lehman Brothers & FactSet.

Integrated Providers

Fiduciary Banks

Total Average Earning Assets

Loans

59%

Ot her 

Earning 

Assets

4 1%

Funding 

M arket 

Funding

36%

O perating Revenues

Loans

24.2%

Core Fee 

Inco me

4 1.4 %

IB Core

8.3%

NIB Core

11.9 %

Ot her

0.4%

Trading / 

Gains13 .8 %

O perating Revenues

Loans

7.9%

Core Fee 

Income

71.2 %

IB Core

2.4%

NIB Core

4 .1%

Ot her

8.0% Trading / 

Gains

6.5%

Total Average Earning Assets

Loans

Ot her 46%

Earning 

Assets

54%

Funding 

M arket 

Funding

43%

Total Average Earning Assets

Loans

37% Ot her 

Earning 

Assets

63%

Funding 

M arket 

Funding

12 %

Int erest 

Core

58%

19
For Super Regionals, Mid Caps, and Small Caps, Loans Are a Very Large Portion of the Asset 

Many of These, a High Level of Core Deposits Helps Stabilize the Rise in Yields in the Front-

Stickiness to Low Rate Deposits. Yet, the Overall Flat Curve Requires a Need to Take on AddStabilize Potential NIM Compression...

O perating Revenues

Loans

28.3%

Core Fee 

Inco me

4 4 .1%

IB Core

10 .8 %

NIB Core

7.5%

Ot her

Trading / 7.5%

Gains

1.8 %

Super Regionals

___________________________Source: Lehman Brothers & FactSet.

Mid-Cap Banks

Small-Cap Banks (East Coast/Mid-Atlantic)

Total Average Earning Assets

Loans

71%

Ot her 

Earning 

Assets

29%

Funding 

M arket 

Funding

29%

Equit y

4 %

Loans

30.8%

Core Fee 

Income

38.6%

IB Core

12 .4 %

NIB Core

10 .1%

Ot her

7.0%

Trading / 

Gains

1.1%

Loans

44.3%

IB Core

12 .0 %

Core Fee 

Inco me

2 8 .1%

Trading / 

Gains

0.4%

Ot her

7.5%

NIB Core

7.8%

Total Average Earning Assets

Loans

75%

Ot her 

Earning 

Assets

25%

Funding 

M arket 

Funding

22%

Equit y

5%

Operating Revenues

Total Average Earning Assets

Loans

74%

Ot her 

Earning 

Assets

26%

Funding 

Equit y

3 %

M arket 

Funding

46% 

Operating Revenues

20
Historically However, Loan Growth Took Place Alongside of a Flattening Curve... Presumabl

Economy Drove Loan Demand While the Fed Flattened the Curve to Restrain Economic Over

 There is high correlation between loan growth and a flattening yield curve. Furthermore, in 2004, fee income represented over 42% of the industry’s revenues. This compare

With fees now contributing 2.5x more to revenues, the industry is less reliant on net interest incom

Loan Growth vs. 5-Year/13-Week Interest Spread Fee Income % Revenues, 1934 

___________________________Source: Baseline, FDIC, Federal Reserve, and Lehman Brothers.

Today however, the flatness of the Curve is driven not by a robust economy 

Corporate demand, it is driven by tremendous technical buying of long Tr

Hence, while loan demand is solid, more risk-taking is necessary to grow out 

asset base...

0%5%

10%15%20%25%30%35%40%45%50%

1934 1941 1948 1955 1962 1969 1976 19

-2%

0%2%4%6%8%

10%12%14%16%

1989 1991 1993 1995 1997 1999 2001 2003 2005

-1.8%-1.2%-0.6%0.0%0.6%1.2%1.8%2.4%3.0%3.6%

Loan Growth 5-yr / 13-wk Spread (right, inverted)

21
International Buying of Treasuries Has Kept the Long-End of the Curve a

Levels... In Addition, Corporate Cap-Ex Growth Is Improving, but Not ECreate Robust C&I Loan Demand...

___________________________Source: Federal Reserve, Bloomberg, FactSet.

4%5%6%7%8%9%

10%11%12%13%

1Q95 4Q95 3Q96 2Q97 1Q98 4Q98 3Q99 2Q00 1Q01 4Q01 3Q02 2Q03 1Q

Capex Operating Income

0%5%

10%

15%20%25%30%35%40%45%50%

Q1.1970

Q1.1972

Q1.1974

Q1.1976

Q1.1978

Q1.1980

Q1.1982

Q1.1984

Q1.1986

Q1.1988

Q1.1990

Q1.1992

Q1.1994

Q1.1996

Q1.1998

Q12000

Treasury Debt US Corporate Debt (Incl ABS)

% of US Debt Held Overseas

S&P 500 (Ex. Financials) – % of Revenues 

22
And the Dramatically Different Nature of Asset Accumulation over the P

Has Created a Dynamic Whereby if Housing Slows, It Will Require Greaof Lending Standards (Higher Risk) to Maintain/Grow Earning Assets...

Proportion of Assets on the Balance Sheet of US Commercial Banks

___________________________Source: Federal Reserve. *Other Loans Not Included.

58%59%60%61%62%63%64%65%66%

Jan-90 Aug-92 Apr-95 Dec-97 Jul-00 Mar-03 

% of Total Assets

Loans (LHS) Securities (RHS)

10%15%20%25%30%35%40%45%50%55%

Jan-73 Jun-78 Dec-83 Jun-89 Nov-94 May-00 

% of Total Loans

C & I Real Estate Consum

Proportion of Loans on the Balance Sheet of US Commercial Banks

C & I Real Estate Consumer

19.3% 53.3% 13.2%30.7% 36.3% 18.0%37.2% 53.4% 22.3%18.7% 24.6% 13.2%

Last

Avg.

Max

Min

23
This Is Not a Crisis Building... There Are Many Factors as to Why the C

Influencing Activity... Yet, There Are Many Countervailing Factors WhiImpact vs. Prior Cycles... It is important to note the four factors below:

– Bank stock performance is much less correlated with the yield curve 

20 years relative to the prior 20 years

– Loan growth, particularly C&I, tends to accelerate when the yield cu

aiding net interest income

– Net interest margins have declined in 9 of the past 13 quarters, 11 of 

years, and are at their lowest level since 1977 (more than 25 years), s

compression is not a new phenomenon

– Fee income represents more than 42% of the industry’s revenues, com

18% in 1977. With fees now contributing 2.5x more to revenues, the les reliant on yield curve-sensitive net interest income

24
Levered Money/Hedge Funds

In 2004, the Carry/Trade Was Very Lucrative for Levered Money... Low Rates, Especially at Allowed for Investment in Virtually All of the Fixed Income Asset Classes with a Positive RetVery Much in Place...

2005 Total Return2004 Total Return

In 2005 and 2006, the primary competitor to Levered Money investment and 

impediment to positive carry positioning is “Cash.”

0.002.004.006.008.00

10.0012.0014.00

EMG S&P

500

3-Month

T-Bill

FRN Treasury HY MBS Credit ExAutos AGG Agency ABS 

0.002.004.006.00

8.00

10.0012.00

EMG HY S&P

500

Credit

Ex-Autos

Credit MBS AGG CMBS Treasury Agency ABS 

25
The Flatter Curve Has a Profound Impact on the Fundament

of Levered Money Business Models... Earn:

– {Risk Free Rate + FX risk + Liquidity Premia + Curve Premia + Option Premia + Defau

(Leveraged Amount + Equity Capital)

 Pay:

– Money Mkt rate x Leveraged Amount x FX

 Return:

– (Earn-Pay x FX Move)/Equity Capital

Plain Vanilla Capital Management Fundamental Investment Equation

 Look at their investment choices to determine which risks they are trying given market opp Look at their incentive structure to determine their investment horizon

26
 Looking at a Carry Trade Example - Six Months Forward in different curve shapes and its effect on breakevens

– Scenario A: Normal Curve (5’s vs Bills is +30)

• Buy 5yr UST @ 4.306% (99-24)• Carry = 12cents• 6 month Break Even Yield = 4.341% (+3.5bp)

– Scenario B: Inverted Curve (5’s vs Bills is -20)

• Buy 5yr UST @ 4.306% (99-24)• Carry = -13cents• 6 month Break Even Yield = 4.279% (-2.7bp)

 You have cushion in a positive carry environment which allows for better risk reward tradesFlatter Yield Curves Create Multiple Challenges for Levered Models... All Derivatives Are a Forwards, and When They Buy Bonds and Repo Them They Are Getting Long the Bond ForwSimplest Form of This and the Most ‘Leverage-able’ Is the Pure Treasury Carry Trade...

When You Incorporate Lack of Roll Down and Neg Carry It Becomes Pretty Sca

 Without the benefit of roll down you need 3bps of roll down to breakeven

– Scenario A: 4’s vs 5’s is Pos 25bp

• Buy 5yr UST @ 4.306% (99-24)• Roll down = +25bp• Unlevered Total Return = 5.2%

– 100x Levered Return = 80% (assumes 4.4% Repo Rate)– Scenario B: 4’s vs 5’s is flat

• Buy 5yr UST @ 4.306% (99-24)• Roll down = 0bp• Unlevered Total Return = 4.3%• 100x Levered Return = -10% (assumes 4.4% Repo Rate)

– Scenario C: 4’s vs 5’s is Neg 25bp

• Buy 5yr UST @ 4.306% (99-24)• Roll down = -25bp• Unlevered Total Return = 3.4%• 100x Total Return = -100% (assumes 4.4% Repo Rate)

27
So, What Do You Do??? 

 Adapt the Business Profile to 

this Environment... Take on new risks (more risk?)

– Structured risk (More 

Derivative Usage)

– Higher Yielding Asset 

classes – Emerging Market Investments, MiddleMarket Lending, Distressed Securities, Private Equity, LBO Funding, Special Situations/Opportunistic...

Global Credit Derivatives Outstanding ($ Billions) 

as a Percentage of Global Credit Index Principal Outsta

This dynamic continues into ’06.... 

The flatness of the curve has profound implications for these con

___________________________Source: ISDA, Lehman Brothers.

Bank 

Portfolio 

Managers

Re-insurers

Bank Portfolio 

Managers

Re-insurers

Hedge Funds

Bank Portfolio 

Managers

Re-insurers

Hedge Funds

Insurance Companies

Asset Managers

Bank Portfolio Managers

Re-insurers

Hedge Funds

Insurance Companies

Asset Managers

Corporations

28

270 560

1,025

1,522 1,971 2,192

12,430

1,802 2,305

2,381

2,900

3,520

4,079

4,867

3,779

8,424

5,312

5,795

214.5%

158.6%

77.7%

24.3%

15.0%

53.7%

43.0% 52.5%

56.0%

0

3,0006,0009,000

12,00015,000

1997 1998 1999 2000 2001 2002 2003 2004 2005

C.D. Outstanding and Market Value of 

Global Credit Index

Credit Derivatives Outstanding

Global Credit Index Principal Outstanding

Credit Deriv. % of Global Credit Index
Con
GDP & The Housing Market/Consumer

 The strength of the relationship between the Yield Curve & GDP are breaking d However, the flat yield curve is reflective of market participants confidence in 

ability to reign in long term inflation

 The absolute level of interest rates impact the “affordability” of housing Historically, the shape of the curve has dictated where housing is financed. Dur

curve environment, 30 year mortgages will see greater volume as the “cost of eis cheaper”

 Today’s hybrid mortgage products (highlighted earlier) along with the absolute 

interest rates has created abnormal short end mortgage financing

 This could cause consumer default risk in 2007 to unusually spike higher in a p

relatively strong GDP growth and low unemployment

29
Insurance Companies

 Today’s low yields, flat curve, and tight credit spreads are a challenging enviro

Insurers

 The long duration nature of Whole Life Insurance and Fixed Annuity sales bec

disintermediated by higher-return/short-duration savings products like bank CD

 And the front end of the curve rising simply compounds the negative sales pic

Traditional Life and Fixed Annuity products which offer a smaller (if any) incplay compared with short-duration alternatives

 Given that reinvestment yields have forced down spreads on fixed-rate produc

has responded by lowering crediting rates on its products to partially offset the portfolio yield

 The income statement impact is straightforward, lower sales (volume) and con

product spreads (margins) will negatively affect earnings...

 Hitting yield bogies are becoming tougher and tougher, consequently Insuranc

are using more structured credit products as a means to satisfy their end

 Clearly regulation curtails their risk appetite, but in a sustained flat curve envir

risky asset classes continue (on the margin) to do well, they will continue to tetolerance within their (regulation & rating agency) boundaries

30
Banks

 The Yield Curve does matter However, it matters less today The decline in NIM’s are both secular (competition in a historically low loan gr

environment) & cyclical (Yield Curve)

 Consequently, the Industry has used its Balance Sheet in the Bond Markets Clearly Small Cap Banks have a higher sensitivity to loans and a lower sensitiv

income compared to their larger counterparts

 This will drive more consolidation in the banking sector which could have imp

Corporate as well as Consumer lending

31
Levered Money

 The Yield Curve can dictate the level of risk/reward appetite A steeper curve can present a utopian environment for hedge funds In this scenario, Equity markets (traditionally) do poorly, Credit spreads are wi

market volatility is higher

 This tends to cause large asset mis-pricing, creating opportunities in two related 

– It’s easier for them to profit in volatile markets– It’s easier for them to raise capital/retain existing funds

 Consequently, a flat yield curve is a tougher environment for the opposite reaso

the former

 Risk appetites will grow and stay high in a flat curve environment

32