Credit Conditions: Favorable North American Credit Conditions Remain Susceptible To Significant Domestic And Global Risks

Primary Credit Analyst: John J Bilardello, New York (1) 212-438-7664; john.bilardello@standardandpoors.com Secondary Contact: Robert Palombi, Toronto (1) 416-507-2529; robert.palombi@standardandpoors.com

Table Of Contents
The Macroeconomic Environment Financing Conditions Risks And Imbalances Sector Outlooks Credit Trends Should Remain Stable, Despite Global Weakness Related Research

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Credit Conditions: Favorable North American Credit Conditions Remain Susceptible To Significant Domestic And Global Risks
(Editor's Note: Standard & Poor's Credit Conditions Committees meet quarterly to review macroeconomic conditions in each of four regions (Asia-Pacific, Latin America, North America, and Europe, the Middle East and Africa). Discussions center on identifying credit risks and their potential ratings impact in various sectors, as well as borrowing and leading trends for businesses and consumers. This article reflects the view developed during the North American Credit Conditions Committee discussion on July 24, 2013.) Credit conditions in North America remain broadly favorable and in-line with our second-quarter assessment. Economic growth in the U.S. and abroad has generally been slower than Standard & Poor's Ratings Services had anticipated earlier in the year. However, U.S. household balance sheets have improved and are helping the country's growth prospects, unlike in Canada, where elevated household debt remains a constraint on the country's growth potential. Despite these mixed trends, we expect the current pace of growth in North America will continue to support credit conditions. U.S. Treasury yields rose in the second quarter but remain low from an historical perspective, and financial conditions are still robust, although more volatile than they have been in recent quarters. We expect U.S. monetary policy to remain accommodative through 2014 and the normalization of interest rates to be gradual. Sequestration cuts will likely stay through year-end, but the private sector's resilience has helped offset the drag from government spending. The rebound in the U.S. housing market continues to strengthen and is spilling over to consumer spending. However, slow growth such as we are observing in North America makes the economy vulnerable to significant domestic and global risks. We continue to see eurozone developments, U.S. fiscal policy, the slowing Chinese economy, and market reaction to the quantitative easing exit process as the primary risks to credit conditions in the region.

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Credit Conditions: Favorable North American Credit Conditions Remain Susceptible To Significant Domestic And Global Risks

Overview North American credit conditions are essentially unchanged from the second quarter and remain broadly favorable. We expect moderate improvement in U.S. economic conditions in the second half of the year, with some strengthening in 2014, while Canada's growth potential is constrained by high consumer debt. Global growth has been slower than we anticipated in the second quarter, particularly in China. Financial conditions will likely remain favorable near term, but the market could become more volatile as the Federal Reserve normalizes monetary policy. The accommodative monetary policy bias continues to hurt banks' spread and fee income, as well as net interest margins. The life insurance sector still faces headwinds from low interest rates, while the mortgage insurance sector should return to profitability in 2014. Corporate credit conditions continue to be mostly favorable, but challenges remain for revenue growth prospects. Public finance entities are maintaining a cautious stance in the face of slower economic growth. Structured finance credit conditions continue to improve for most sectors, led by housing and consumers. Eurozone developments, U.S. fiscal policy, the slowing Chinese economy, and a disorderly market response to the quantitative easing exit are the top risks we are monitoring.

The Macroeconomic Environment

The U.S. economy is expected to gain momentum through 2014
We expect moderate improvement in U.S. economic conditions in the second half of the year, with some strengthening in 2014. However, it now seems unlikely that Washington lawmakers will reach a compromise on sequestration any time soon, and the negative effects of federal spending cuts will likely linger through year-end. Because of this drag, as well as a sharp downward revision to first-quarter GDP, we now expect the U.S. economy to expand just 2.0% this year--down from our forecast of 2.7% in April. We still expect growth to strengthen next year, however, to around 3.1%. The positive factors we see for U.S. growth prospects are: the surprising resilience in the private sector, which has helped to counterbalance the weight of sequestration; the rebound in the housing market and its positive effects on consumer spending; the boom in energy-related production, which has provided support to the Midwest and had downstream benefits for manufacturing and exports; continued modest employment growth; and the improvement in private balance sheets. In addition, inflation remains low, which we expect will allow the Fed to gradually taper bond purchases and to keep monetary policy accommodative in the near term. We continue to see the risk of recession at 10%-15%. However, our downside scenario calls for low growth rather than a traditional recession (generally defined as two consecutive quarters of contraction). In this scenario, U.S. real GDP rises 1.5% this year and 0.6% in 2014. This scenario could occur due to a fiscal policy mistake or an external shock from, for example, Europe or China, with the former mired in recession and growth and the latter slowing slightly more than we had expected.

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Credit Conditions: Favorable North American Credit Conditions Remain Susceptible To Significant Domestic And Global Risks

In our upside scenario, which we see as having a 15%-20% chance, real GDP would expand 2.6% this year and 4.9% in 2014. This scenario entails more normal, healthy growth characterized by a stronger housing recovery and a more robust increase in consumer and business spending, as well as agreement in Washington on a sound deficit-reduction plan.

Canada continues to lag the U.S.

In Canada, we still expect the economic recovery to continue, albeit at a more subdued pace, with real GDP rising about 1.7% this year. Slower growth in China and Europe's recession continue to hurt Canada's growth prospects. Stagnant commodity prices will likely restrain investment spending and hiring in Canada's natural resource industries. We also expect slower consumer spending as households focus on paying down debt. The Canadian real estate market is cooling and the accumulation of household debt is ebbing along with a slowdown in residential mortgage borrowing. By the middle of 2013, personal income growth began to outpace demand for credit and households' debt-to-disposable income edged lower. We expect financial deleveraging to remain a focus for Canadian consumers in 2014 and this could constrain the economy's growth potential. But, we expect real GDP growth to pick up to 2.5% in 2014, as a stronger U.S. economy benefits Canadian exports. In our downside scenario, to which we assign a 10%-15% probability, Canada would return to a mild recession characterized by stagnating activity toward the end of 2013 that cuts real GDP growth to 1.2% this year. In this downside scenario, we're assuming the country's economy would continue to struggle with contracting GDP in the first half of 2014, further reducing growth to just 0.4% for the year. For 2015, we would expect GDP growth to average 2%, which is below our baseline forecast of 2.9% for the year. Our downside scenario for Canada assumes the U.S. economy stumbles and returns to sub-2% GDP growth rates in 2013 and 2014, Europe struggles through a deeper/longer downturn, or slower growth in China's economy undercuts commodity prices. Our upside scenario, with a one-in-10 chance, assumes real GDP would expand 2.4% this year and 2.9% in 2014, supported by stronger growth in the U.S. and China, which would bolster demand for commodities.

Global growth is modest, with China slowing further

Global growth has been slower than we anticipated in the second quarter, and we have lowered our forecasts for many important economies outside North AmericaChina in particular. Given evidence of further deceleration in economic activity and indications that Chinese authorities have become more willing to tolerate slower growth, we now expect real GDP growth of 7.3% this year and next (relative to our previous forecasts of 7.9% and 7.8%, respectively). In general, economies in the Asia-Pacific region have softened this year, with the notable exception of Japan, where reflation policy has shown an early positive impact. We still expect the eurozone to remain in recession through year-end, with a meaningful recovery still a ways off. We lowered our base-case growth forecast for 2013 to -0.8% (from -0.5% last quarter) as economic weakness spread more to the core economies, particularly Germany and the Netherlands. The deleveraging process continues to hurt the region, while monetary and financial conditions remain highly fragmented. We continue to forecast a weak and fragile recovery in 2014, with growth of 0.7%. As it stands, we see a one-in-three chance of a deeper recession this year that could continue into 2014.

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Credit Conditions: Favorable North American Credit Conditions Remain Susceptible To Significant Domestic And Global Risks

Table 1

Standard & Poor's Real GDP Growth Scenarios For North America
Baseline forecast (%) 2013f Canada U.S. f--Forecast. 1.7 2.0 2014f 2.5 3.1 2015f 2.9 3.0 Upside scenario (%) 2013f 2.4 2.6 2014f 2.9 4.9 2015f 3.1 4.0 Downside scenario (%) 2013f 1.2 1.5 2014f 0.4 0.6 2015f 2.0 2.2

Financing Conditions
For now, the financial environment should continue to support current credit conditions
While possibly less robust than in the second quarter, financial conditions remain generally favorable and support current credit conditions. Long-term Treasury yields rose sharply in May through early July but have since stabilized. At about 2.5% currently, the Treasury 10-year yield is about 100 basis points higher than the low in May, but remains well below the long-term average of 4.5% since 2000. Mortgage rates have risen along with Treasury yields: At 4.3%, the 30-year fixed-rate mortgage is still lower than its 5.5% average for the past decade. In Canada, financing conditions are following a similar path and the government's 10-year bond yield (2.35%) is up almost 70 basis points since the end of April. With the Bank of Canada not yet signaling its intention to raise its policy rate (1%), the short-term government bond yields that banks use to price residential mortgages haven't increased as much. In fact, the five-year fixed mortgage rate that chartered banks use to qualify homebuyers has moved very little since April. The steepening government yield curve and modestly widening credit spreads are raising long-term borrowing costs for nonfinancial corporate borrowers; however, their funding costs remain about 200 basis points below an effective rate of 6% that companies were paying on short- and long-term borrowing before the financial crisis hit in 2007. According to the Bank of Canada, senior loan officers at Canadian financial institutions reported a continued easing in lending conditions for nonfinancial companies in the second quarter of 2013, so access to bank credit hasn't tightened along with the rising bond yields. Bond market performance and new issuance have also revived, after falling sharply in recent weeks. In addition, the stock market has continued to advance, with the S&P 500 index rising almost 20% this year to a record high. We also expect the Fed to gradually taper bond purchases and to keep monetary policy accommodative through 2014. Thus, financial conditions will likely remain favorable for credit conditions in the near term. However, the market may become more volatile, as observed in May-June 2013, as the Fed normalizes its monetary policy.

Risks And Imbalances

Global risks could weigh on currently positive credit conditions
We continue to see further fallout from eurozone problems as a top risk to global credit conditions. Europe is still grappling with recession and a sovereign-banking crisis. As time goes by, our biggest worries are a persistent lack of vision on how to tackle growth, especially on the periphery of Europe, and the widespread debt overhang in large parts of the region.

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Credit Conditions: Favorable North American Credit Conditions Remain Susceptible To Significant Domestic And Global Risks

U.S. fiscal policy shock or uncertainty also continues to be a key risk, in our view. The longer the sequestration drags on, in our view, the harder it will be for the private sector to sustain growth. Meanwhile, the continuing resolution is set to expire in September and the debt ceiling will likely be breached in early fall. There is scant evidence that Congress will agree on this point and contentious negotiations could harm business investment and consumer spending. The risk of a correction in China is increasing as the government aims to transform the economy so that it relies less on investment growth and more on consumption. The challenge, however, lies in growing consumption sufficiently to counter a slowdown in investment. The potential fallout from the credit boom and frothy real estate market are also ongoing concerns. We consider a disorderly market response from the end of quantitative easing as an important risk because of its potentially unanticipated and disruptive consequences. The Fed's return to a more normal monetary policy, even under orderly circumstances, could still weigh on credit conditions because the shift could lead to higher borrowing costs for consumers and businesses, weaker collateral performance, and losses for financial institutions. We continue to monitor the impact of accommodative monetary conditions and investors' search for yield. These conditions could be paving the way for credit growth and easing underwriting standards, which could weaken credit quality in the future.
Table 2

Top Global Risks Third-Quarter 2013

Risk Contagion from eurozone problems Likelihood Plausible Trend Stable Potential causes Eurozone banking sector problems deepen and spread; systemically important financial institution collapses; eurozone recession becomes deeper/longer; radical, non-euro aligned political parties are elected in key eurozone countries Policy mistake/gridlock Investment correction; disorderly deflation of real estate bubble; uncontrolled bank/non-bank sector and local government debt problems; social unrest leading to loss of confidence and economic disruption Adverse market reaction to monetary policy shift; policy mistake Potential effects Financial market turmoil; increased investor risk aversion, with capital outflows from risk assets; funding markets stressed; credit spreads widen; loose monetary policy continues; flight to safe haven currencies; lower commodity prices; tighter trade and capital flows; uncertainty hurts consumer/business confidence, spending and investment, including global FDI; China slows down further; U.S. recession/slowdown Loose/easing monetary policy; U.S. recession/slowdown; credit spreads widen Reduced Chinese imports of commodities, raw materials, capital equipment; Chinese consumer spending weakens, Chinese government spending increases; adverse impact on global trade and growth; lower commodity prices; deeper/longer eurozone recession; U.S. recession/slowdown; credit spreads widen Asset repricing/deflation (e.g., Treasuries, equity markets, high-yield, emerging markets); higher interest rates and cost of capital; higher financing costs weigh on business investment, consumer spending, and housing market; U.S. recession/slowdown; slower capital flows to and growth in emerging markets

U.S. fiscal policy shock/uncertainty Sharper-than-anticipated slowdown in China

Plausible Plausible

Stable Increasing

Disorderly market response from end of quantitative easing

Plausible

Stable

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Credit Conditions: Favorable North American Credit Conditions Remain Susceptible To Significant Domestic And Global Risks

Sector Outlooks
Most sectors should hold steady
Overall, we expect satisfactory economic/business conditions and stable rating trends to continue over the next 12 months. We anticipate that conditions for regional banks and financial companies and most of structured finance will remain strong, while ongoing sequestration cuts should continue to weigh on defense and health care. Slower growth in China will continue to hurt metals and mining, where we still expect weaker business conditions and negative rating trends. The business outlook continues to improve for sectors linked to housing, such as building materials, homebuilders, REITs, and mortgage insurers. The sector outlook for large complex banks and private student loan asset-backed securities (ABS) remains stable to negative. And, overall corporate credit quality remains healthy. We forecast the U.S. speculative-grade default rate will increase to 3.3% by March 2014 from 2.5% at the end of the second quarter, still below the historical average of 4.5%.

Banks will have to contend with an accommodative monetary policy bias in second-half 2013
In our view, an accommodative monetary bias will continue to pressure banks' spread and fee income and net interest margins in 2013, as banks replace higher-yielding assets with lower-yielding investments. For large complex banks, we expect low interest rates to constrain revenue growth; mortgage banking revenue gains to be lower due to increased competition and reduced refinancing volume; capital-markets revenues to remain the same or decline slightly on a year-over-year basis; credit costs to diminish relative to 2012, with most of the improvements focused in real-estate portfolios; capital ratios to increase at a more modest pace; and liquidity to remain at or near current levels in 2013. The business outlook for regional banks, on the other hand, is somewhat stronger even though we expect compressed net interest margins will continue to constrain top-line growth. That said, regional banks may be able to partially mitigate margin compression by accelerating loan growth, reducing operating expenses, lowering funding costs, or releasing additional reserves. Nevertheless, we expect noninterest income to remain elevated for a few more quarters, particularly for those regional banks with substantial mortgage operations. We expect balance sheets to remain strong, with institutions focused on meeting Basel 3 targets and maintaining fairly conservative capital ratios. Cyclical improvements in asset quality will continue, in our view, but at a declining rate. Financial trends for both large and regional banks are unchanged from the last quarter. For the industry as a whole, loan growth will remain tepid in 2013. We expect bank managements will continue to keep costs under control even as they incorporate changes from the Dodd-Frank Act. Meanwhile, we believe operating leverage will remain negative. As a result of low rates, we expect to see some banks chasing yield, which could weaken credit quality over time. The migration to higher risk areas could occur through either the loan book or the securities portfolio. We expect capital distributions (payouts) to increase across the board in 2013, but do not yet see this as a risk for either large complex or regional bank ratings because current capital levels are high, although we expect the rate of build will taper off. We have a negative outlook on a greater proportion of large complex banks (at the holding company level) largely due to the overhang from regulation. Management teams for several of these banks are still working through legacy mortgage issues, including legal exposures, regulatory agreements and settlements, mortgage repurchase liabilities, and generally higher costs and credit risk. For regional banks and finance companies, by contrast, we see a positive to

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stable sector outlook, and a higher share of positive rating outlooks supports this view. Tail risk for U.S. banks could result from a sharp rise in interest rates, whereas external risk could arise from the potential impact of a deepening recession in the eurozone (neither is part of our base case).

Traditional asset managers are benefitting from the strong equity markets
Most of the asset managers we follow have benefited from the gradually improving economy in recent periods, particularly rising equity markets. While continued rising interest rates (or a potential reduction in the Fed's quantitative easing program) would negatively affect asset managers who rely heavily on fixed income, the broad belief of a gradual rotation to equity investing bodes well for rated asset managers. Nearly all of the large managers we follow have a substantial equity product offering. With the strong rally in the equity markets year-to-date, most of these managers achieved strong growth in assets under management, and we expect this growth to continue, which bodes well for financial trends this year.
Table 3

Financial Institutions Sector Conditions

Current business conditions Large complex banks Regional banks Finance companies Asset managers Weak Weak Satisfactory Satisfactory Business outlook (next 12 months) No change Somewhat stronger Somewhat stronger Somewhat stronger Financial trends (next 12 months) Same Same Same Higher Sector outlook (next 12 months) Stable to Negative Positive to Stable Positive to Stable Positive to Stable

Low interest rates will test the life insurance sector in 2014, while the mortgage insurance sector will likely return to profitability
Under the baseline economic forecast, our ratings outlook for all North American insurance sectors remains largely stable; however, a sluggish economic recovery in the U.S. is vulnerable to significant domestic and global risks that could negatively affect ratings. Under Standard & Poor's baseline economic assumptions, we expect life insurers to maintain strong balance sheets with relatively flat earnings. Although the industry has a competitive suite of insurance, savings, and retirement products, as well as effective distribution, it continues to face headwinds from low interest rates, potential equity market volatility, and a soft domestic economy. Low interest rates will continue to make products such as fixed-rate deferred annuities and universal life insurance less attractive for both consumers and insurers. Insurers whose product portfolios include fewer spread- or interest-sensitive life insurance and retirement products and more fee-type products will likely fare better under our economic forecasts. To counter low interest rates and preserve investment yields, many life insurers have increased allocations to less-liquid asset classes, including commercial mortgage loans, private placement bonds, ABS, and alternative investments, although so far these moves have been modest. For property/casualty insurers and reinsurers, our stable credit quality viewpoint is generally supported by strong capital levels and conservative investment portfolios. Under our base-case economic forecast, we expect premium growth to trend above GDP levels in 2013 as property/casualty insurers successfully increase premium pricing to mitigate the impact of persistently low interest rates. During the last 10 years, we have seen an uptick in both the

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Credit Conditions: Favorable North American Credit Conditions Remain Susceptible To Significant Domestic And Global Risks

frequency and severity of catastrophe losses. In fact, the seven-largest catastrophe events took place during this time. We are beginning to view these catastrophes as the new normal and, accordingly, are budgeting greater catastrophe losses in our earnings projections. Inflation hits property/casualty insurers harder than other sectors because a general rise in prices could inflate claims costs faster than insurers can update premium rates. We therefore believe that the expectation for low inflation in our base-case forecast is positive for the property/casualty insurance industry. Health insurers continue to benefit from higher private company payrolls, but we are beginning to see indications that medical inflation is increasing. While we still expect medical inflation to gradually migrate back toward its pre-2010 level, it is increasingly more likely that inflation will settle closer to the current level--lower than the historical but higher than the recent level--due in part to structural factors. Industry risk remains somewhat elevated because of the upcoming market transition, but the potential for significant downside development will likely be limited. Thus far, the new rules and regulations have not hurt the sector and many health insurers have developed a better sense of risk and opportunity. We expect mortgage insurers to remain unprofitable for 2013, although losses are trending much lower than in 2012. The overall credit quality of new business writing is strong and we expect it to remain so for the foreseeable future. However, legacy portfolios continue to generate new notices of delinquency and losses, albeit at lower rates. As the housing market gradually improves, business writings in this sector will grow, in our opinion, and the sector will return to profitability in 2014.
Table 4

Insurance Sector Conditions

Current business conditions Life Insurers Property and casualty insurers Health insurers Mortgage insurers Reinsurers Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Business outlook (next 12 months) No change No change No change Stronger No change Financial trends (next 12 months) Same Same Same Higher Same Sector outlook (next 12 months) Stable Stable Positive to Stable Stable Stable

Corporate credit conditions continue to be generally strong, but challenges remain for revenue growth prospects
The pace of corporate new issuance declined in the second quarter of 2013 from the robust levels in the first quarter, predominantly due to the uncertainty overhang surrounding the Fed's monetary policy. So far in the third quarter, however, more stable yields seem to have reinvigorated new issuance. Corporate balance sheets remain strong, supported by lower borrowing costs due to issuers opportunistically tapping the capital markets multiple times to push out pending maturities and lower overall borrowing costs. While the recent increase in interest rates and financial market volatility pared back covenant-lite loan issuance at the tail-end of the second quarter, new issuance for leverage loans in the third quarter has again been predominantly covenant lite. From an economic perspective, we now assume that certain sectors will feel the effects of U.S. sequestration through year-end. Surprisingly, however, resilience in the private sector is helping to offset the drag from government spending cuts. In particular, the housing market's recovery has strengthened, while consumer spending continues to increase at

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a solid pace. Against this macroeconomic backdrop, we expect weak business conditions for those sectors that are most exposed to sequestration, such as defense, health care, and capital equipment, and stronger business conditions for sectors closely tied to the housing market, such as building materials, homebuilders, and REITs. Meanwhile, slowing industrial demand from Europe and China continues to hurt the coal and industrial metals sectors. And given this slower growth, as well as ongoing overcapacity in segments such as steel, we do not expect a recovery in the metals and mining sector in the near term. We believe the recent increase in mortgage rates could temper demand in housing; however, we do not believe rising mortgage rates will derail the sector's recovery because demand/supply dynamics will likely remain favorable through 2014. Indeed, from a credit perspective, more moderate growth in demand could be welcome because it would likely reduce the need for external capital while relieving some cost pressures from the tight supply of land, labor, and material. Currently, economic and business conditions in the corporate sector remain satisfactory and, as such, we do not expect significant changes in rating trends. However, an unexpected sharp increase in interest rates, further weakness in the global economy, or another recession in the U.S. could have an adverse impact on ratings. Furthermore, a material and sustained increase in oil and gasoline prices could erode consumer purchasing power, which would then hurt consumer discretionary segments while simultaneously increasing cost pressures for sectors that rely heavily on the input. However, given the slowdown in China and protracted weakness in Europe, coupled with the added production arising from fracking and shale exploration, we expect oil prices to ultimately stabilize once geopolitical uncertainties subside.
Table 5

Corporates Sector Conditions

Current business conditions U.S. corporates Aerospace and defense Autos Auto suppliers Transportation Capital goods Oil and gas Chemicals Forest products Metals and mining Building materials Real estate - homebuilders REITs Consumer products - durable Consumer products - food, beverage Consumer products - personal care, consumer services, apparel, and tobacco Pharma and healthcare Retail Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Somewhat weaker No change No change No change Somewhat weaker No change Somewhat stronger No change Somewhat weaker Somewhat stronger Stronger Somewhat stronger No change No change No change Somewhat weaker No change Same Same Same Same Same Same Higher Same Lower Higher Lower Lower Same Same Same Same Same Stable to Negative Stable Stable Stable Stable Stable Stable Stable Stable to Negative Positive to Stable Positive to Stable Stable Stable Stable Stable to Negative Stable to Negative Stable to Negative Business outlook (next 12 months) Financial trends (next 12 months) Sector outlook (next 12 months)

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Table 5

Corporates Sector Conditions (cont.)

Media and entertainment Leisure and sports Technology Telecom/cable Regulated utilities Midstream energy Merchant power PPPs/infrastructure project finance Canadian corporates Transportation Oil and gas Chemicals Forest products Metals and mining Building materials Retail Media and entertainment Telecom/cable Utilities Midstream energy Merchant power/PPP Satisfactory Satisfactory Satisfactory Satisfactory Weak Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Somewhat stronger No change No change No change Weaker Somewhat stronger No change No change No change No change No change No change Higher Same Same Same Lower Higher Same Same Same Same Same Same Positive to Stable Stable to Negative Stable Stable to Negative Negative Stable Stable Stable to Negative Stable Stable Stable Stable Satisfactory Satisfactory Weak Satisfactory Satisfactory Satisfactory Weak Satisfactory No change Somewhat stronger Somewhat stronger No change No change Somewhat weaker No change No change Same Same Higher Same Same Lower Same Same Stable to Negative Positive to Stable Stable Stable Positive to Stable Stable Stable to Negative Stable

The public finance sector remains cautious in the face of slower economic growth
State and local government: We anticipate that state and local government credit quality will remain relatively stable through the rest of 2013, but we feel it's still susceptible to a faltering economic recovery. If that were to occur, we would expect more negative rating actions considering that most governments are still in varying phases of fiscal repair. For most state and local governments, the new fiscal year began on July 1, 2013. Although the fiscal outlooks for many states and localities are considerably more stable than in recent years, some now anticipate that tax revenue growth could slow compared with early in 2013. As a result, we observe that most governments are staying cautious with their budgets for the new fiscal year. Despite the opportunity for rising revenues to restore programs that governments had cut during the downturn, governments have been noticeably reluctant to commit to materially higher spending trajectories. After losing 737,000 jobs (3.72%) from the peak in July and August 2008, the state and local government sector slowly started to add jobs. And with stronger state budgets, they have begun restoring some areas that had been cut, especially in education. May 2013 was the fourth-consecutive month of job gains in the state and local sector--something of a new trend. That said, this growth only amounts to an increase of 0.19% (36,000 jobs) nationwide for those months. Furthermore, in June 2013, state and local governments pulled back, cutting 2,000 jobs. A recovering housing market is particularly important for municipal governments that levy retail sales taxes as part of their revenue base. In the bigger picture, we think that discussions about potential reductions or the elimination of the

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home mortgage interest deduction at the federal level risk weakening conditions in the real estate market. Enterprises: Recently lowered GDP growth projections temper many public finance enterprises' growth-related capital investment needs. Moreover, the federal budget sequestration funding implications have not changed our expectation for stable ratings in sectors such as U.S. public finance, healthcare, housing, and transportation's grant anticipation revenue vehicles because these sectors' financial performance shows capacity for ratings resilience. Unemployment and a moderately strengthening economy continue to constrain ratemaking flexibility for U.S. public finance, utilities, and transportation credits, but slow growth has also reduced spending pressures on rates. As the economy improves, capital spending needs might rebound, but ratemaking flexibility could also improve as consumer confidence increases. Affordability remains a challenge for both public and private higher education credits, where demand elasticity pressures tuition revenues. Standard & Poor's expects health care reform legislation will counter unemployment's impact on healthcare system visits and reimbursements. The legislation will likely increase insurance coverage over time, initially through government subsidies and later through insurance mandates. For now, cost cutting and consolidation remain the tools of choice for preserving financial metrics. However, as cost-cutting opportunities diminish, it increases the potential for negative implications regarding financial performance. Standard & Poor's projects improving business conditions for the housing sector as single-family housing starts reach approximately 1 million in 2014, up from 530,000 in 2012. Also, two-year average loan delinquency rates of 7.5% remain at a fraction of our stress-case assumptions. Nevertheless, for many municipal housing issuers, low interest rates reduce investment income and tax-exempt bond financed loans' competitive position compared to taxable financings erode net income. Low interest rates also expose those with variable-rate index-based swaps to payments that exceed receipts from counterparties; such swaps are common among housing finance agencies. In the near term, diminished loan production tempers credit exposures as issuers deleverage and build equity. As the U.S. Treasury reduces its mortgage-backed securities purchases and interest rates rise, loan production could also increase. For U.S. public finance enterprises beyond housing, low interest rates temper borrowing costs, which helps preserve credit metrics. However, recent moderate increases in interest rates have reduced financing activity. We continue to observe that U.S. public finance credits can generally withstand economic contractions such as those set out in Standard &Poor's downside case scenarios.
Table 6

Public Finance Sector Conditions

Current economic/business conditions States Satisfactory Economic/business outlook (next 12 months) Somewhat stronger Somewhat stronger No change Somewhat weaker Somewhat stronger No change Financial trends (next Sector outlook (next 12 months) 12 months) Lower Higher Same Same Same Same Stable Stable Stable Stable Stable Stable

Local governments Satisfactory Higher education Health care Housing Electric utilities Somewhat stronger Satisfactory Satisfactory Satisfactory

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Table 6

Public Finance Sector Conditions (cont.)

Water and sewer utilities Airports and ports Toll roads and bridges Garvees Higher education Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory No change No change No change No change No change Same Same Same Same Same Stable Stable Stable Stable to Negative Stable to Negative

Credit conditions are favorable for the structured finance sector

Structured finance credit conditions continue to improve for most sectors, led by housing and consumers, but the dynamics of the credit markets have shifted as spreads have become more volatile and investors continue to rotate from bonds to equities. U.S. structured finance collateral performance has generally been benefitting from improving economic growth. While the credit outlook is generally stable among the structured finance sectors, without a change in fundamentals from higher rates, those rising rates and easing lending standards remain a concern. Rising interest rates and widening spreads on these securities without an improving economy could generally hurt collateral performance in many key structured finance sectors. While the labor market is slowly improving, a high unemployment rate also remains a concern and we expect lenders will continue to ease underwriting standards across these sectors, which could lead to modest increases in collateral losses. Housing continues to improve and we expect home prices to rise 11% this year. However, it remains a concern whether the sector can sustain the current pace of double-digit gains in home prices. We expect rising mortgage rates to slow refinancing and the housing market recovery, but we don't believe these strong price gains will last long. It's also premature to describe the current market as being in a bubble because home values are still well below their pre-recession peaks. The $1 trillion market for student debt--which has been growing faster than the overall economy--could have adverse fundamental implications on consumer spending and first-time home purchases in the long run, in our view. Finally, we believe the impact of ongoing regulatory uncertainties in the financial industry could reduce credit availability and liquidity capacity and create refinancing risk for some sectors.
Table 7

Structured Finance Sector Conditions

Current business conditions Residential mortgages RMBS RMBS Re-REMICS RMBS - servicer advancing RMBS - tax liens Commercial mortgages CMBS - U.S. conduit/fusion CMBS - Canadian conduit/fusion Satisfactory Satisfactory Somewhat stronger Somewhat stronger Same Same Stable Stable Satisfactory Weak Satisfactory Satisfactory Somewhat stronger No change Somewhat stronger Somewhat stronger Same Same Same Same Stable Stable to Negative Stable Stable Business outlook (next 12 months) Financial trends (next 12 months) Sector outlook (next 12 months)

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Credit Conditions: Favorable North American Credit Conditions Remain Susceptible To Significant Domestic And Global Risks

Table 7

Structured Finance Sector Conditions (cont.)

CMBS - large loan/single borrower CRE-CDO/Re-REMIC Asset-backed securities ABS - auto loans ABS -auto lease ABS - credit cards ABS - FFELP student loan ABS - private student loan ABS - commercial equipment Asset-backed commercial paper Structured credit CLOs Synthetic CDOs Market value (includes leveraged funds) Trust preferred securities Structured counterparties Timeshares Small business Tobacco Transportation Hedge funds and private equity CFOs Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Weak Satisfactory Satisfactory Somewhat stronger Somewhat stronger Somewhat stronger Somewhat stronger Somewhat stronger Somewhat stronger Somewhat stronger No change No change Somewhat stronger Same Same Same Same Same Same Same Same Same Same Positive to Stable Stable Stable to Negative Positive to Stable Stable to Negative Stable Stable to Negative Stable Stable Stable Satisfactory Satisfactory Satisfactory Satisfactory Weak Satisfactory Satisfactory Somewhat stronger Somewhat stronger Somewhat stronger Somewhat stronger No change Somewhat stronger No change Same Same Same Same Same Same Same Stable Stable Stable Stable Stable to Negative Stable Stable Satisfactory Weak Somewhat stronger No change Same Same Stable Stable

Credit Trends Should Remain Stable, Despite Global Weakness

Overall credit conditions in North America remain broadly favorable, but significant downside risks remain. We expect the U.S. and Canadian economies will continue to expand and strengthen through 2014 in our base-case scenario, which should help mitigate continued economic weakness in Europe and slower growth in China. While borrowing costs have risen from the second quarter, they remain low from an historic perspective. Credit quality remains healthy and we expect overall rating trends to remain generally stable. U.S. sequestration cuts and the slowdown in the Chinese economy are hurting a few sectors, but those tied to the U.S. housing market continue to improve. Standard & Poor's projects the U.S. speculative-grade default rate will increase to 3.3% by March 2014 from 2.5% at the end of the second quarter, still below the historical average of 4.5%.

Related Research
Credit Conditions: Europe Lacks A Vision For Growth As Traction From Other Regions Diminishes, July 29, 2013
Additional Contacts:

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Credit Conditions: Favorable North American Credit Conditions Remain Susceptible To Significant Domestic And Global Risks

Devi Aurora, New York (1) 212-438-3055; devi.aurora@standardandpoors.com David N Bodek, New York (1) 212-438-7969; david.bodek@standardandpoors.com Erkan Erturk, PhD, New York (1) 212-438-2450; erkan.erturk@standardandpoors.com Farooq Omer, CFA, New York (1) 212-438-1129; farooq.omer@standardandpoors.com Gabriel J Petek, CFA, San Francisco (1) 415-371-5042; gabriel.petek@standardandpoors.com Jennelyn U Tanchua, New York (1) 212-438-4436; jennelyn.tanchua@standardandpoors.com David C Tesher, New York (1) 212-438-2618; david.tesher@standardandpoors.com Paul Sheard, New York (1) 212-438-6262; paul_sheard@standardandpoors.com Beth Ann Bovino, New York (1) 212-438-1652; bethann.bovino@standardandpoors.com

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