DISTORTIONS IN THE DISTORTIONS IN THE SECURITIES MARKETSSECURITIES MARKETS

Wayne Klein

Lewis B. Freeman & Partners, Inc.

October 17, 2008

Five Market Distortions Five Market Distortions that Impact Investors and that Impact Investors and the Economy Today:the Economy Today:

Auction-Rate SecuritiesHedge/Pension Fund Trading

PracticesCredit Default SwapsDark PoolsSynthetic Securities

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1. AUCTION-RATE 1. AUCTION-RATE SECURITIES:SECURITIES:BackgroundBackground

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.

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Marketing of ARS: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.

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Design of the auction: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.

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The “Dutch” auction: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.

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Unwanted outcomes: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.

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Quiz – Auction example: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?

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Answers: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.10

Collapse of auctions: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.

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(Belatedly) Redeeming (Belatedly) Redeeming ARS: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.

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Redemption still waits for Redemption still waits for some: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.

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The future look of ARS: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.

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2. HEDGE/PENSION FUND 2. HEDGE/PENSION FUND TRADING PRACTICES: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.

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Hedge fund influence: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.

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What are the concerns?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.

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Near-term regulatory Near-term regulatory changes: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 .

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Market-induced changes: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?

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Long-term changes: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?22

3. CREDIT DEFAULT 3. CREDIT DEFAULT SWAPS: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.

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CDS impact: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.

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Concerns: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.

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Bear Stearns: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.

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Role of CDS in financial Role of CDS in financial meltdown: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?

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Short-term effects: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.28

Regulatory reaction: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.

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Long-term changes: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

performanceMore CDS terms will be standardized.

◦Trading may move to exchanges.CDS are almost certain to be regulated.

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4. DARK POOLS: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.

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How they work: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.

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How prevalent are they?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.

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Concerns with dark pools: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.” 34

Recent developments: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.

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Future developments?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.

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5. SYNTHETIC 5. SYNTHETIC SECURITIES: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.

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Total Return Equity Swaps Total Return Equity Swaps (TRS):(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.

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Why?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.39

Concerns with equity Concerns with equity swaps: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.

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TCIF proxy battle with TCIF proxy battle with CSX: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.

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Consequences: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.

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Conclusions: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?

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Contact Information:

Wayne Klein

Lewis B. Freeman & Partners, Inc.

_____

3225 Aviation Avenue, Suite 501

Miami, FL 33133

(305) 443-6622

www.lbfglobal.com

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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.

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