DISTORTIONS IN THE SECURITIES MARKETS

1. DISTORTIONS IN THE SECURITIES MARKETS Wayne Klein Lewis B. Freeman & Partners, Inc. October 17, 2008

2. Five Market Distortions that Impact Investors and the Economy Today: • Auction-Rate Securities • Hedge/Pension Fund Trading Practices • Credit Default Swaps • Dark Pools • Synthetic Securities

3. 1. AUCTION-RATE SECURITIES:Background • Auction-rate securities (ARS) are long-term bonds and preferred stock whose interest rates are set by investors in weekly or monthly auctions. • Issuers are primarily municipalities, closed-end mutual funds, student loan companies, and corporations. • Issuers get lower rates on long-term money; investors earn above money-market rates.

4. Marketing of ARS: • Originally, ARS had $250,000 minimum; recently sold to public investors in $25,000 increments. • $330 billion in ARS outstanding in Jan. 2008. • Institutions held 80% of ARS at end of 2006, only 30% at end of 2007. • Brokerage firms sold ARS to investors saying they were liquid, safe, short-term, and equivalent to cash or money-market funds.

5. Design of the auction: • Auction is run by BD selected by issuer. • ARS are auctioned at par (face) value. • The only variable is the interest rate. • Interest rate is determined using a form of “Dutch” auction: the lowest bids buy the securities.

6. The “Dutch” auction: • Investors submit bids, indicating how many ARS are wanted – at what interest rate. • The securities will be sold to the investors submitting the lowest bids. • The highest interest rate required to sell out the ARS is the “clearing rate.” • All investors who bid the clearing rate or lower will get ARS at the clearing rate.

7. Unwanted outcomes: • If all existing holders submit “hold” bids, it is an “all-hold” auction. A below-market interest rate is paid. • If there are not enough bids to buy all ARS offered, it is a failed auction. A “penalty” interest rate (up to 20%) must be paid. • BDs want to avoid both results. All-hold auctions harm customers; failed auctions harm issuers.

8. Quiz – Auction example: • Looking at the 4/18/08 auction results for Presbyterian Hospital (on the next slide): • What is the penalty rate? • What is the all hold-rate? • What is the clearing rate? • Who gets the securities offered for sale?

10. Answers: • The penalty rate is 15%. • This gives the hospital (the issuer) strong incentive to make sure the auction succeeds. • The all-hold rate is 1.582%. • This penalizes the investors if they all hold. • The clearing rate is 2.6%. • The clearing rate was determined by the UBS customer that bid for the entire issue at 2.6%. • The lowest 7 bidders get all 101 shares bid. • The 8th bidder (here, the issuer) gets 192 shares.

11. Collapse of auctions: • On Feb. 13, 2008, all major BDs stopped financial support of auctions. • 87% of auctions failed. • $300 billion in ARS was frozen. • 60% of auctions have continued to fail since. • Penalty rates were triggered. • Even successful auctions and fixed-rate bonds are now paying higher rates. • Investors cannot get access to their funds.

12. (Belatedly) Redeeming ARS: • Municipal bonds with high penalty rates are redeeming ARS, using new bond money. • Some mutual fund ARS have been redeemed. • Investors could borrow from BD or sell in secondary market (discounts of 5-50%). • States forced BDs to re-buy ARS in August. • UBS, Morgan Stanley, JP Morgan, Citigroup, Wachovia, Merrill, Goldman, Deutsch, B of A. • Will repurchase $65 billion in ARS at par.

13. Redemption still waits for some: • Mandated ARS repurchase is not complete: • Mutual fund ARS not required to be redeemed; • Holdings by institutions, wealthy not covered; • Purchases through non-auction BDs still open. • Some customers have filed suit/arbitration. • Criminal charges and investigations: • Credit Suisse RRs charged for lying about ARS. • Inquiry: Did Lehman dump ARS on customers? • Inquiry: Insider trading by UBS official who sold.

14. The future look of ARS: • Small investors will cease participating. • MSRB plans a website with information on the outcome of ARS auctions. • MSRB predicts a smaller market will survive. • Mutual funds will offer “put option” bonds. • Guarantors (banks) will agree to buy the ARS from customers if the auction fails. • These will be sold only to institutional buyers. • Some predict ARS market will disappear. • Rates will be higher.

15. 2. HEDGE/PENSION FUND TRADING PRACTICES: It is a new world! Consider: • Mutual funds frequently were using derivatives to boost their returns; • 42% of pension funds had planned significant increases in hedge fund investments; • 35% of 2006 M&A value was private equity: • 31,825 deals involving $4 trillion in value • $255 billion in going-private transactions.

16. Hedge fund influence: • The 8,000 hedge funds existing in early 2008 controlled $1.9 trillion in assets. • 87% of money is in large funds over $1 billion. • Big funds influence business operations: • Icahn’s proxy fight with Yahoo over Microsoft • Battle for board seats at CSX • Hedge funds control more traditional assets: • Largest shareholders of 4 biggest airlines • Control 60% of oil futures.

18. What are the concerns? • Unfunded pension liabilities may be encouraging excessive risk taking. • A higher failure rate for private buyouts. • The investment climate and surfeit of hedge funds invites insider trading, manipulation. • Speculators, not hedgers, are primary purchasers of commodity futures contracts. • Much trading is driven by off-exchange swaps. • Exchange trading = $5 trillion, OTC = $9 trillion. • Commodity prices are a speculative bubble.

19. Near-term regulatory changes: • CFTC, Congress investigating speculation: • Is institutional trading the cause of price rises? • CFTC now admits high speculator influence. • Financial crisis will result in more regulation: • SEC investigating manipulation by hedge funds. • Hedge fund regulation may be coming. • Regulation of swaps, off-exchange transactions. • Short selling limitations. • Enron and London loopholes will be closed: • Monitoring of electronic and overseas trading .

20. Market-induced changes: • Collapse, consolidation of hedge funds: • Less leverage available as result of credit crisis, • Short-selling prohibition impacted many funds, • Negative returns: some funds down 20% • Boone Pickens’ funds are down $1 billion for the year. • High withdrawal rate, low inflows of new funds. • The concern is that an increase in withdrawal requests will unleash a vicious cycle of funds selling assets at distressed prices, to cover withdrawals, and losses on those sales will result in more withdrawals. • Is a commodity bubble collapsing?

22. Long-term changes: • Congress may limit swaps, commodity speculation by hedge/pension funds. • Higher margin rates suggested. • Hedge fund tax rates may increase. • Shine on hedge funds will disappear: • Warren Buffet bet $1 million that stocks will beat hedge funds over a 10-year period. • More regulation of the markets is certain, due to the financial upheaval. • Will this drive some trading overseas?

23. 3. CREDIT DEFAULT SWAPS: • Swaps are private agreements that let investors bet on companies’ financial health. • In exchange for periodic payments, a swap issuer agrees to pay if a company defaults on its bonds. • Swaps may be written by insurers or BDs. • Uses: subprime debt, bond insurers, companies. • Swap prices are skyrocketing. • CDS for GM, Ford cost $9 M for $10 M bonds. • Risk premiums have quadrupled since April 2007. • Investors use CDS as proxy for stocks.

24. CDS impact: • Greenspan had predicted sale of CDS would spread risk. • Risk actually was magnified as the same buyers bought most of the CDS, then defaults rose. • Swaps became a $62 trillion market, are now driving prices in cash bond market. • Market is over the counter, unregulated. • Many analysts think swap market pricing overstates the risk of losses.

25. Concerns: • CDS are used as proxy for stock purchases. • Trading contributes to massive volatility. • CDS specialists may be gaming the system. • Swap holders often don’t know identity or creditworthiness of CDS counterparties. • Difficult to properly value a swap when one does not know if counterparty will perform. • When risks rise, buyers demand collateral. • This precipitates liquidity problems.

26. Bear Stearns: • In early March, a run began on Bear Stearns. • Other BDs worried about Bear’s ability to perform counterparty obligations, so they started demanding collateral from Bear. • Mar. 14: Fed seized Bear, forced sale to JP Morgan, guaranteeing $29 billion in credit. • Fed was motivated by counterparty risk – that Bear’s failure would trigger others. • Vigorous argument about moral hazard.

27. Role of CDS in financial meltdown: • Seizure of Fannie & Freddie triggered CDS default, $1 trillion worth of contracts. • Lehman was large CDS issuer, won’t pay. • $400 Bn in Lehman CDS on $155 Bn of debt. • CDS prices for Morgan, Goldman spiked. • AIG was big issuer of CDS ($400 billion): • As prices spiked, AIG put up $14 Bn collateral. • This capital need hastened AIG’s failure. • New standard: “too interconnected” to fail?

28. Short-term effects: • Country credit problems: Iceland CDS at 50% • Higher capital for BDs, become banks, BHCs. • Bond insurers downgraded, might fail. • Issuers cannot get AAA ratings. • Banks are protecting against default risk. • Some banks tie interest rates to swaps prices. • Participants must settle defaulted CDS. • Confidence problem: will sellers pay debts? • CDS issuers may be unable to buy bonds to settle • Zero-sum game: a winner for every loser.

29. Regulatory reaction: • SEC has expanded its insider trading probe to include CDS: focus is on hedge funds. • CDS prices often swing ahead of corporate news. • NY A.G. is investigating whether short-sellers spread negative rumors, to profit on CDS bought at cheaper prices. • NY insurance department said certain types of CDS would be regulated as insurance. • Some sellers must become insurance companies.

30. Long-term changes: • BDs are eliminating swaps that cancel each other out – to improve clearance. • In September, volume dropped by $7.4 trillion. • Clearinghouses being formed to trade CDS, other instruments having counterparty risks. • Clearinghouses would guarantee performance • More CDS terms will be standardized. • Trading may move to exchanges. • CDS are almost certain to be regulated.

31. 4. DARK POOLS: • Dark pools are private electronic trading platforms used to anonymously trade stocks away from the exchanges. • Operated by BDs, exchanges, ECNs. • Used by hedge funds, private equity to trade large blocks of stock: • Large trades don’t move markets to get filled. • Avoids broker front-running or copycatting. • Hides intentions of buyers and sellers • Faster execution, lower transaction costs.

32. How they work: • One pool installs its software on traders’ systems to watch for comparable opposing-side orders between firms. • A match pops up for firms with relevant orders. • Price is usually the midpoint of buy-ask spread. • Trades are executed continuously. • Another system aggregates trades for hourly cross-matching. • “Gray pools” let traders send indications of interest to other pool participants.

33. How prevalent are they? • Represent 12% of U.S. daily stock trades. • There may be over 100 dark pools. • Top five have over half the volume. • 17% of NASDAQ trades are dark orders. • The volume of block orders traded on exchanges has dropped dramatically. • NYSE reported a record 10.27 billion shares traded Sept. 18: • 1.1 billion shares routed through 3 dark pools.

34. Concerns with dark pools: • There are concerns that dark pools: • Siphon liquidity from the markets; • Distort price discovery; • Mask intentions of traders; • Increase fragmentation of markets; • Reduce efficiency of public markets; • Facilitate manipulation, self-dealing; • Increase volatility. • Exchanges are at a competitive disadvantage. • Pools overstate volumes, to appear “deeper.”

35. Recent developments: • Exchanges view dark pools as threats: • Exchanges offer their own dark pools, serve as portals to route transactions to other pools. • Firms such as Morgan, Goldman, UBS are granting access to each other’s pools. • While linking improves liquidity and pricing, it does not increase transparency. • Predators game the pools, learning order size and intentions, then backing away. • This information could facilitate manipulation.

36. Future developments? • Regulators may demand more transparency. • Harder for BDs to ensure best execution. • Pools will trade options, derivatives. • Denial of access to predators/gamers. • Closure, consolidation of pools. • Further consolidation among exchanges. • Big brokerage firms will have advantages. • Continued growth will raise questions that dark pool trading may cause systemic risk.

37. 5. SYNTHETIC SECURITIES: • Synthetic securities are used to profit from price movements, and influence conduct – without owning the securities. • Synthetic securities are most commonly created by: • Buying options (puts and calls) on the stock; • Engaging in equity swaps. • CDS are ingredients in many synthetics. • Synthetic securities are used for short selling, proxy battles, arbitrage, hedging.

38. Total Return Equity Swaps (TRS): • Party A (short party) creates TRS swap with B (long party) based on company X’s stock. • These are privately negotiated OTC agreements. • A B cash equivalent of: • Dividends paid by X, • Increase in market value of X stock. • B A cash equivalent of: • Interest payments based on the value of X, • Decrease in market value of X stock.

39. Why? • A receives: • Set interest rate, instead of market returns, • Protection against price decreases. • B gets: • All upside benefits of owning stock, except voting, • Greater leverage because stock is not purchased. • A may buy or borrow stock to hedge risk. • Both have economic interests in the stock, but not ownership interests.

40. Concerns with equity swaps: • Decoupling of economic interest and voting interests. • Distortion of corporate governance: • Hedgers may withhold votes or ask swap buyer. • Manipulation can be done more cheaply. • If no Williams Act filings, TRS holders can: • Hide their intentions • Concentrate large positions in hands of short parties. • Prevent others from bidding up stock.

41. TCIF proxy battle with CSX: • Two activist hedge funds amassed large CSX position, pushed for changes to boost price. • TCIF bought TRS equal to 14% of CSX stock. • Funds told CSX they controlled $800 M in stock. • TCIF began proxy contest. CSX sued, saying TCIF failed to make Williams Act filing. • TCIF said because swaps are not stock, no duty. • Court: TCIF broke law; proxy still permitted. • TCIF won four board seats in June.

42. Consequences: • Williams Act applies to synthetic securities. • The court called TCIF arguments formalistic, an apparent effort to defeat purposes of the law. • TCIF still got to vote shares it controlled. • Britain’s FSA increased disclosure duties: • Hedge funds must disclose swap holdings; • Must reveal short positions in rights offerings. • Congress may require disclosure of TRS use. • SEC is being urged to act. • Company bylaws are requiring disclosure.

43. Conclusions: • The U.S. securities markets continue to be dynamic and innovative. • This usually benefits investors and the economy. • Markets innovate faster than regulation. • Regulators should not channel market changes. • Distortions or abuses will occur. • Because Wall Street failed to prevent abuses, Congress and regulators will intervene. • When our technology outpaces our ability to regulate, how should regulators react?

44. Contact Information: Wayne Klein Lewis B. Freeman & Partners, Inc. _____ 3225 Aviation Avenue, Suite 501 Miami, FL 33133 (305) 443-6622 www.lbfglobal.com _____ 299 South Main, Suite 1300 Salt Lake City, UT 84111 (801) 534-4455 (801) 824-9616 (cell) wklein@lbfglobal.com • LBF is a forensic accounting and litigation consulting firm that: • Acts as receiver and trustee, • Performs forensic accounting, • Conducts due diligence, internal investigations, • Provides professional advising on internal controls, SOX compliance, • Manages restructurings and business workouts, • Provides specialized subject-matter expertise in securities, commodities, banking, hotel, and real estate, and • Serves as expert witness.