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Page 1: Financial Pacific: Financial crisis thermometers (third party) october 26.2010

Thomas Berner, CFA, economist, [email protected], +1 212 713 4108, UBS FS

Wealth Management Research 25 October 2010

Financial crisis thermometers

Monthly update■ In this monthly report, we measure financial, economic and credit

health with the help of "thermometers."

■ The financial health thermometer deteriorated in the US andEurozone, but improved in the UK and Japan.

■ The US economic health thermometer deteriorated a bit in Septemberbut remains firmly within the healthy zone.

■ The US credit health thermometer deteriorated slightly in Septemberand continues to stand at a slightly worse level than normal.

US financial health (updated monthly, last update 22 October 2010):Please see the Appendix for a detailed explanation of this thermometer.The US financial health thermometer deteriorated visibly from 100.9°on 17 September to 101.3° on 22 October. All four components ofthe thermometer except equity volatility deteriorated. The corporatecredit spread deteriorated the most, as the corporate yield rose andthe Treasury yield fell. The spread widening will likely not persist, as anongoing expansion will likely improve corporate credit fundamentals. Thethermometer's current level is close to the upper limit of the range thathas been established since the escalation of the Greek fiscal crisis in April.Before that crisis erupted, it stood at 100.5°. However, it is still much closerto healthy territory than the levels recorded at the height of the financialcrisis in October 2008. To reflect a full normalization, it will have to improvefurther to a level of 100°.

US economic health (updated monthly, last update 22 October2010): Please see the Appendix for a detailed explanation of thisthermometer. The US economic health thermometer deteriorated from99.3° in August to 99.1° in September. At that level, it is marginallybelow the midpoint of the healthy range which is consistent with realGDP growth between 0% and 3%. The ISM Manufacturing PurchasingManagers' Index (PMI) and the Conference Board consumer confidenceindex fell in September and while non-farm payroll growth was slightlyweaker in September compared

US financial health thermometerDETERIORATEDNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

Source: Thomson Datastream, UBS WMR, as of 22 October 2010

US economic health thermometerDETERIORATEDNormal index (sample: Feb 1969 – present) = 100

Source: Thomson Datastream, UBS WMR, as of 22 October 2010Past performance is no indication of future performance. The market pricesprovided are closing prices on the respective principal stock exchange. Thisapplies to all performance charts and tables in this publication.

This report has been prepared by UBS Financial Services Inc. (UBS FS).Please see important disclaimers and disclosures that begin on page 9.

Page 2: Financial Pacific: Financial crisis thermometers (third party) october 26.2010

with August. Given our outlook for only a moderate recovery, we think theindex will likely stay within the healthy range, with a tendency to be closerto 100° than 98.5°.

US credit health (updated monthly, last update 22 October 2010):Please see the Appendix for a detailed explanation of this thermometer. TheUS credit health thermometer deteriorated slightly from 100.3° in Augustto 100.4° in September. The contraction in commercial bank lending was abit more pronounced, and corporate credit spreads widened in September.On a trend basis, credit health has improved from a historical high of 104.5°in November 2008 and now stands at a level slightly worse than normal.In our view, it will probably stay close to a normal reading of around 100°.

US credit health thermometerDETERIORATEDNormal index (sample: Jan 1973 – present) = 100

Source: Thomson Datastream, UBS WMR, as of 22 October 2010

Eurozone financial health (updated monthly, last update 22 Octo-ber 2010): Please see the Appendix for a detailed explanation of this ther-mometer. The Eurozone financial health thermometer deteriorated slightlyfrom 101.0° on 17 September to 101.1° on 22 October, effectively fully re-versing its improvement over the prior measurement period. Only the mon-ey market spread deteriorated, but it rose strong enough to offset smallgains in the other three components. The current level of the thermometeris within the range established after the Greek fiscal crisis in April, and isnot terribly alarming compared to its level in late 2008.

Eurozone financial health thermometerDETERIORATEDNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104

Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10

Thermometer Thermometer (excl. CDS)

Unhealthy

Healthy

Source: Thomson Datastream, UBS WMR, as of 22 October 2010

UBS Wealth Management Research 25 October 2010

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UK financial health (updated monthly, last update 22 October 2010):Please see the Appendix for a detailed explanation of this thermometer.The UK financial health thermometer improved visibly from 101.0° on 17September to 100.7° on 22 October. All four components of the ther-mometer improved, with the corporate credit spread improving the most.The level of the thermometer is fairly healthy.

UK financial health thermometerIMPROVEDNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104

Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10

Thermometer Thermometer (excl. CDS)

Unhealthy

Healthy

Source: Thomson Datastream, UBS WMR, as of 22 October 2010

Japan financial health (updated monthly, last update 22 October2010): Please see the Appendix for a detailed explanation of this ther-mometer. The Japan financial health thermometer improved a bit from100.5° on 17 September to 100.4° on 22 October. All four componentsof the thermometer except the credit default swap spread improved. Outof all four measured regions, Japan has suffered the least from the Greekcrisis and also has the lowest (i.e. healthiest) level.

Japan financial health thermometerIMPROVEDNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10

Thermometer Thermometer (excl. CDS)

Unhealthy

Healthy

Source: Bloomberg, UBS WMR, as of 22 October 2010

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AppendixFinancial health thermometersThe financial health thermometer is a weekly gauge of financial stress. Con-ceptually, we constructed it in the same way for all four regions: the US,the Eurozone, the UK and Japan. Due to data limitations in Japan, however,the construction of the Japanese thermometer is a little bit different. Thefinancial health thermometer is the weighted average of four "standard-ized" indicators, where standardized means that the original series weretransformed to have a mean of zero and a standard deviation (volatility)of one. The weights are assigned according to the explanatory power ofeach indicator of the variance in the whole data set (Principal ComponentAnalysis). The four indicators are:

■ Bank liquidity: measured by the difference between money marketrates and central bank rates. Specifically, it is the spread of the 3-monthLondon Interbank Offered Rate (LIBOR) interest rate over the respectivecentral bank target rate. The higher the spread goes, the harder it isfor banks to get liquidity.

■ Corporate default: measured by the difference between corporatebond rates and government bond rates. Specifically, it is the spread ofthe investment grade 10-year corporate bond yield over the 10-yeargovernment bond yield. The higher the spread goes, the higher therisk of corporate default.

■ Financial intermediaries default: measured by the five-year creditdefault swap (CDS) spread of the financial intermediaries sector. TheCDS spread measures the cost of insuring an underlying credit securityagainst default over a certain period (in our case, five years). The higherthe spread goes, the higher the aggregate risk of default of financialintermediaries. In Japan, a CDS spread for the financial intermediariessector was not available. We used the average CDS spread of the threebiggest banks in Japan (Mitsubishi UFJ, Sumitomo Mitsui and Mizuho)instead.

■ Equity volatility: measured by the implied volatility of the major stockmarket indexes. The implied volatility indexes are based on the impliedvolatility as priced into option prices on the underlying stock indexes.The higher the implied equity volatility goes, the more investors arewilling to pay to hedge against equity volatility and, thus, the higherthe perceived equity risk is in the market.

The interpretation of the financial health thermometer is constructed asfollows: We used the period between 1 January 2006 and 20 July 2007as the benchmark for “normal” (the benchmark period). In late July 2007,the first financial market dislocations occurred following the US subprimemortgage crisis. While any choice for a benchmark is arbitrary, we are inter-ested in knowing when we will reach the financial health that existed be-fore the July 2007 liquidity crisis. Each regional financial health thermome-ter in this report averages 100 over the normal benchmark period, so anindex level of 100 is considered normal.

US financial health thermometerNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104

105

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Thermometer Thermometer (excl. CDS)

Unhealthy

Healthy

Source: Thomson Datastream, UBS WMR, as of 22 October 2010

Eurozone financial health thermometerNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Thermometer Thermometer (excl. CDS)

Unhealthy

Healthy

Source: Thomson Datastream, UBS WMR, as of 22 October 2010

UK financial health thermometerNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Thermometer Thermometer (excl. CDS)

Unhealthy

Healthy

Source: Thomson Datastream, UBS WMR, as of 22 October 2010

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Page 5: Financial Pacific: Financial crisis thermometers (third party) october 26.2010

■ To make the measurements easier to interpret, we introduced aFahrenheit degree scale, where 100° indicates normal body temper-ature. Each Fahrenheit degree deviation from 100° equals 10 stan-dard deviations from the mean that existed during the normal bench-mark period. For example, a financial health thermometer that standsat 103° is 30 standard deviations above its mean during the normalbenchmark period. This might seem like a lot, but we are comparingthe current financial health to the normal benchmark period, whenvolatility was very low.

■ Each Fahrenheit degree also has its own color zone, with a higher de-gree associated with a higher temperature and thus poorer health. Thecolor scheme goes from green (healthy) to increasingly darker shadesof yellow and up to dark orange or red (unhealthy).

Since we used the same normal benchmark period and methodology forall four regions, the levels of each regional financial health thermometerare comparable. Keep in mind, however, that the Japanese thermometerwas constructed slightly differently.

Japan financial health thermometerNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Thermometer Thermometer (excl. CDS)

Unhealthy

Healthy

Source: Bloomberg, UBS WMR, as of 22 October 2010

All financial health thermometersNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104

105

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

US Eurozone UK Japan

Unhealthy

Healthy

Source: Thomson Datastream, Bloomberg, UBS WMR, as of 22 October 2010

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US economic health thermometerThe economic health thermometer gauges the stance of the US economyin a single and timely measure on a monthly basis. This gauge will helpinvestors assess whether the US economy is moving out of recession beforeit shows up in the GDP figures.

The economic health thermometer is the weighted average of three “stan-dardized” indicators, where standardized means that the original serieswere transformed to have a mean of zero and a standard deviation (volatil-ity) of one. The weights are assigned according to the explanatory power ofeach indicator of the variance in the whole data set (Principal ComponentAnalysis). The three indicators are:

■ Business climate: measured by the level of the Institute for SupplyManagement (ISM) Manufacturing Purchasing Managers’ Index (PMI).The ISM surveys purchasing managers at manufacturing firms everymonth on changes in new orders, unfilled orders, production, employ-ment, supplier delivery times, inventory, export orders, imports andprices paid. The ISM Manufacturing PMI is the average of the sub-in-dexes for new orders, production, employment, supplier delivery timesand inventories. A level above/below 50 signals an expansion/contrac-tion in the national manufacturing sector. The ISM index correlatesstrongly with real GDP year-over-year growth and is thus seen as agood proxy for overall economic activity. However, manufacturing cy-cles can sometimes diverge from the overall business cycle. Thus, careis required when interpreting the level of the ISM index.

■ Consumer sentiment: measured by the level of the ConferenceBoard (CB) consumer confidence index. The CB index gauges howconsumers assess their present and future situation. The index is con-structed as the average of the indexed answers to five questions aboutconsumers’ assessment of the current and future employment situa-tion, current and future business conditions and future total family in-come. The answers can be positive, negative or neutral. For each ques-tion, the sub-index is derived by calculating the ratio of the proportionof the positive answers to the sum of the positive and negative an-swers. This number is then indexed, with 1985 equaling 100. Thus, thelevel of the CB consumer confidence index is not readily interpretableas positive or negative, but has to be compared to its history to assesswhether or not the value is conducive to real consumption growth.The index dates back to February 1969 and averaged 95.4 throughFebruary 2009. A level of around 90 is consistent with trend growthof about 3.5% in real consumption.

■ Labor market health: measured by the monthly growth rate in non-farm payrolls, which count the number of jobs in the entire economy,excluding the farm sector. Although non-farm payrolls tend to get re-vised rather sharply, they swing more in line with real economic activitythan the unemployment rate, which typically lags the overall businesscycle. Non-farm payroll growth of 0.16% per month, or about 2%annually, is considered normal employment growth or commensuratewith trend growth in real GDP.

US economic health thermometerNormal index (February 1969 – present) = 100

96

97

98

99

100

101

102

103

Feb-69 Feb-79 Feb-89 Feb-99 Feb-09

US economic health thermometer

Unhealthy

Unhealthy

Healthy

Source: Thomson Datastream, UBS WMR, as of 22 October 2010

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Page 7: Financial Pacific: Financial crisis thermometers (third party) october 26.2010

The interpretation of the economic health thermometer is as follows:

■ The average of the entire sample from February 1969 to the currentmonth equals 100.

■ To make the measurement easier to interpret, we introduced a Fahren-heit degree scale, where 100° implies normal body temperature. EachFahrenheit degree deviation from 100° equals one standard deviationfrom the mean over the entire sample. For example, an economichealth thermometer that stands at 102° is two standard deviationsabove its sample mean.

■ There are three color zones.

■ The green zone (from 98.5° to 100°) is commensurate with real GDPgrowth between zero and 3%, with the latter being trend growth overthe sample period.

■ The dark orange zone (100° or higher) is commensurate with real GDPgrowth above 3%, or an overheating economy.

■ The blue zone (98.5° or lower) is consistent with contracting real GDP,or a recessionary economy.

We classify both an overheating and a recessionary economy as un-healthy, and see normal growth between zero and 3% as healthy.Note that the boundaries between healthy and unhealthy are blurred.Ideally, the US economy should be growing at potential growth ofaround 3%. However, we wanted to mark the line between contrac-tion and expansion (zero growth or 98.5°). That does not mean thatwe think that it would be healthy for the US economy to expand at+0.5% per year for several years.

UBS Wealth Management Research 25 October 2010

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Page 8: Financial Pacific: Financial crisis thermometers (third party) october 26.2010

US credit health thermometerThe credit health thermometer gauges credit conditions in the US on amonthly basis. It summarizes information on the price, availability and flowof credit. The credit health thermometer is the weighted average of five“standardized” indicators, where standardized means that the original se-ries were transformed to have a mean of zero and a standard deviation(volatility) of one. The weights are assigned according to the explanatorypower of each indicator of the variance in the whole data set (PrincipalComponent Analysis). The five indicators are:

■ Bank liquidity: measured by the spread of the 3-month Eurodollardeposit rate over the fed funds rate. We used the 3-month Eurodollardeposit rate instead of the 3-month LIBOR rate since it has a longerhistory. They correlate very closely, however. The higher the spreadgoes, the harder it is for banks to get liquidity.

■ Corporate default: measured by both the spread of the Moody’sAaa 20-year corporate bond yield over the 20-year government bondyield and the spread of the Moody’s Baa 20-year corporate bond yieldover the 20-year government bond yield. The higher that any of thesespreads goes, the higher the risk of corporate default in the respectivesegment of the investment grade corporate bond market.

■ Availability of credit: measured by commercial bank lending stan-dards for consumer installment loans. The higher the standards are,the tougher it is for consumers with low credit ratings to get credit.

■ Loan volume: measured by the real (inflation-adjusted) monthlygrowth rate of commercial bank loans (real estate, business and con-sumer loans). The higher the growth rate goes, the more rapidly loanvolumes on banks' balance sheets are rising.

The interpretation of the credit health thermometer is as follows:

■ The average of the entire sample from January 1973 to the currentmonth equals 100.

■ To make the measurement easier to interpret, we introduced a Fahren-heit degree scale, where 100° implies normal body temperature. EachFahrenheit degree deviation from 100° equals one standard deviationfrom the mean over the entire sample. For example, a credit healththermometer that stands at 102° is two standard deviations above itssample mean.

■ Each Fahrenheit degree has its own color zone, with a higher degreeassociated with a higher temperature and thus poorer health. The col-or scheme goes from green (healthy) to increasingly darker shades ofyellow and up to red (unhealthy). We consider credit conditions be-tween 98° and 100° as generally healthy, with the healthiest creditconditions closest to 100°. Credit conditions are looser as the ther-mometer approaches 98°. Credit conditions that are too loose (suchas extending credit to insolvent borrowers) can also create problems.

US credit health thermometerNormal index (sample: Jan 1973 – present) = 100

97

98

99

100

101

102

103

104

105

106

Jan-73 Jan-83 Jan-93 Jan-03

US credit health thermometer

Unhealthy

Healthy

Source: Thomson Datastream, UBS WMR, as of 22 October 2010

UBS Wealth Management Research 25 October 2010

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Appendix

Global Disclaimer

Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliatethereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, tobuy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materiallydifferent results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible forsale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representationor warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions aswell as any prices indicated are current as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contraryto those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time UBS AG and other companies inthe UBS group (or employees thereof) may have a long or short position, or deal as principal or agent, in relevant securities or provide advisory or other services tothe issuer of relevant securities or to a company connected with an issuer. Some investments may not be readily realizable since the market in the securities is illiquidand therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control theflow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky.Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realizationyou may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of aninvestment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we wouldrecommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein. This document maynot be reproduced or copies circulated without prior authority of UBS or a subsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document tothird parties for any reason. UBS will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report isfor distribution only under such circumstances as may be permitted by applicable law.Australia: Distributed by UBS Wealth Management Australia Ltd (Holder of Australian Financial Services Licence No. 231127), Chifley Tower, 2 Chifley Square, Sydney,New South Wales, NSW 2000. Austria: This publication is not intended to constitute a public offer or a comparable solicitation under Austrian law and will only be usedunder circumstances which will not be equivalent to a public offering of securities in Austria. The document may only be used by the direct recipient of this informationand may under no circumstances be passed on to any other investor. Bahamas: This publication is distributed to private clients of UBS (Bahamas) Ltd and is not intendedfor distribution to persons designated as a Bahamian citizen or resident under the Bahamas Exchange Control Regulations. Canada: In Canada, this publication isdistributed to clients of UBS Wealth Management Canada by UBS Investment Management Canada Inc.. Dubai: Research is issued by UBS AG Dubai Branch within theDIFC, is intended for professional clients only and is not for onward distribution within the United Arab Emirates. France: This publication is distributed by UBS (France)S.A., French "société anonyme" with share capital of € 125.726.944, 69, boulevard Haussmann F-75008 Paris, R.C.S. 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Singapore: Please contact UBS AG Singapore branch, an exempt financial adviser under the Singapore Financial Advisers Act (Cap. 110) and a wholesalebank licensed under the Singapore Banking Act (Cap. 19) regulated by the Monetary Authority of Singapore, in respect of any matters arising from, or in connectionwith, the analysis or report. Spain: This publication is distributed to clients of UBS Bank, S.A. by UBS Bank, S.A., a bank registered with the Bank of Spain. UAE: Thisresearch report is not intended to constitute an offer, sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE). The contents ofthis report have not been and will not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities, theEmirates Securities and Commodities Authority, the Dubai Financial Market, the Abu Dhabi Securities market or any other UAE exchange. UK: Approved by UBS AG,authorized and regulated in the UK by the Financial Services Authority. A member of the London Stock Exchange. This publication is distributed to private clients ofUBS London in the UK. Where products or services are provided from outside the UK, they will not be covered by the UK regulatory regime or the Financial ServicesCompensation Scheme. USA: Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and anaffiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributesreports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated withUBS, and not through a non-US affiliate.Version as per January 2010.© UBS 2010.The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

UBS Wealth Management Research 25 October 2010

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