gerald a. beeson april 14, 2008
DESCRIPTION
PRESENTATION TO Financial Institutions Risk Management Conference. Future of Financial Innovation. Gerald A. Beeson April 14, 2008. Future of Financial Innovation. From Vantage Point of Market Participant. - PowerPoint PPT PresentationTRANSCRIPT
Gerald A. Beeson
April 14, 2008
Future of Financial Innovation
PRESENTATION TO
Financial Institutions Risk Management Conference
2
Future of Financial Innovation
There is much needed innovation within the derivatives market and many innovations of the past decade have been shut down, perhaps permanently, in risk transfer and funding
Derivative Markets
Continuing problems and hazards with respect to liquidity, transparency, valuation and counterparty credit risk
Securitization Markets
Continued impairment of the securitization market will hinder the transference of risk between providers of credit and pools of available capital
Funding Markets
Beginning to recover after the dislocations of Q3/Q4 and the aftermath
From Vantage Point of Market Participant
3
Derivatives Market
“Risk is essential but it needs to be supported. It’s all about the plumbing.”
Drive toward central clearinghouse (central risk pool) where derivative contracts can be submitted, matched, cleared and settled
Resistance to changes that yield a standardized product that creates a more efficient market
Management of gross notional exposures and mitigation of operational risks
Valuation concerns
Valuation reconciliation between counterparties, particularly during periods of market stress
Counterparty credit concerns
Utilization of collateral posted in the ordinary course of their capital markets activities
• Conversely, counterparties have credit risk that they want to mitigate
Movement to exchange based and cleared products eliminates this asymmetrical benefit
• Relieves potential “run on the bank” concerns seen in 2008
Market Participant Observations
4
0
1
2
3
4
5
6
7
8
9
10
Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr
Sca
le F
acto
r
OTC Margin Dispute Trends Example
2008 2009
5
Commitment to Innovative Solutions
6
Impaired Securitization Markets
7
Shutdown of the Securitization Market
In 2001, Citadel launched a Bermuda based reinsurance business offering large scale, collateralized risk transfers of property and catastrophe risks
Positive performance as business grew (ex 2005); however, needed longer term risk management and capital efficiency strategy in order to grow
Asymmetrical return distributions in best and worst cases
Experience in capital markets led to offering of insurance risk-linked securitization with several benefits
• Active market demand and diversified investor base
• Fully collateralized protection
• Multi-year coverage
• Fixed pricing terms
Placed largest bank debt indemnity deal done to date in July 2007 at $500 M
Market Participant Case Study
8
Alignment of Interest
Citadel and investors’ interests remain aligned throughout the term of the transaction
Citadel must cede all policies within the subject business lines – no potential for adverse selection
At inception Citadel funds retained 100% of the first approximately $650mm of losses each year
Cedants covenant to retain at least 50% of ground up losses below the securitized layer
Losses above the securitized layers are retained by Cedants
Term Loan C
Term Loan A
Cedant Retention
Term Loan D
Term Loan B
Net
Los
ses
$1,200mm/P(E) = 0.2 bps
Limits Written
Cedant Retention
Pro Forma Cedants Exposure
$1,015mm/P(A) = 0.7 bps
$875mm/P(A) = 15.6 bps
$710mm/P(A) = 90.4 bps
$650mm/P(A) = 140.0 bps
9
Risk Exposure
Note: MPCI and property per risk are not included in the above analysis.
Analysis of the pro forma portfolio for calendar year 2007 illustrates per occurrence PMLs
All Peril Occurrence PMLs
$650$710
$875
$1,050
$1,200
Term Loan D AttachmentTerm Loan C Attachment
Term Loan B Attachment
Term Loan A Attachment
Term Loan A Exhaustion
$307
$450
$532$596
$684
$805
20 50 100 250 1,000 25,000
Return Period (yrs) Per Occurrence PML
10
Low Probability of Loss ImpactRemodeled Key Historical Events1
$650$710
$875
$1,050
$1,200
Term Loan D AttachmentTerm Loan C Attachment
Term Loan B Attachment
Term Loan A Attachment
Term Loan A Exhaustion
1. 2004 and 2005 hurricanes are modeled using RMS recommended event IDs . Events prior to 2004 are based on stochastically generated storms that are representative of the historical events. Loss figures gross of reinstatement premiums.
2. Katrina does not include marine gulf or flood.
$350
$36 $63 $39 $28 $28 $27
$239
$45 $48
Andrew(1992)
Northridge(1994)
Lothar(1999)
Charley(2004)
Frances(2004)
Jeane(2004)
Ivan(2004)
Katrina(2005)
Rita(2005)
Wilma(2005)
11
Projected Earnings Distribution (Combined Gross/Net)
Projected Earnings Distribution as of 1/1/08
(800)
(600)
(400)
(200)
200
400
50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
Ear
nin
gs (
$m)
Total Gross of Emerson
Total Net of Emerson Percentile Gross Net0.000% 292 271 50.000% 220 199 75.000% 144 123 90.000% (4) (25) 95.000% (143) (164) 98.000% (297) (287) 99.000% (399) (320) 99.600% (502) (355) 99.800% (558) (370) 99.900% (610) (382) 99.998% (851) (459)
Expected 169 150
Key Percentile
-
Cumulative Probability
12
Final Analysis
Cost of capital
Capital structure 75% equity and 25% debt
• Debt layer was 3 year term structure at L+100 up for renewal in May 2009
Consideration of increased capital commitment relative to returns generated from other businesses
Securitization Market
Effectively closed to innovative risk management transaction like Emerson Re
Asymmetrical upside/downside relationship would return to the business
Decision to exit the business
Q4 2008 Considerations
13
Funding MarketsView from the Eye of the Storm
14
Citadel Investment Group
Asset Management Capital Markets
Alternative Asset ManagementMarket Making /
High Frequency TradingCitadel Solutions
• Largest options specialist
• Largest retail equity market maker
• Citadel accounts for approx 30% of US options trading volume and over 8% of US equity volume
• Multi-strategy hedge funds
• Planned single-strategy hedge funds
• Fund administration business offering premium, tailored services to hedge funds
Business Architecture
15
Citadel Derivatives Group LLC
8% of US Equity Volume 29% of US Options Volume
Sept 2008 data
A Market Leader in Equities and OptionsEmbracing “disruptive” technologies to improve liquidity and transparency in the capital markets
16
End of an EraDisappearance of the “Shadow Banking System”
17
Liquidity Reserve
• Maintenance of a pre-funded liquidity reserve to meet contingent cash needs of Citadel’s balance sheet
Counterpart Diversity
• Across both financing and trading counterparts
• Broad distribution of exposures to maintain operational flexibility in a disruptive market environment
• Diverse financing arrangements across highly rated counterparts in robust, efficient structures
Active capital and balance sheet planning
• Targeting the relationship between aggregate risk limits and capital required to support them
• Balance sheet liquidation model: a business unit / strategy analysis of Citadel’s ability to reduce risk positions
Liquidity Management
• Model Citadel’s liquidity ladders to incorporate the following parameters
• Mark-to-Market exposure from stress events
• Expiration of committed funding facilities
• Accelerated Capital Calls
• Reductions in the Balance Sheet of the Firm
Treasury – Liquidity Management PhilosophyEnsure the provision of adequate liquidity to meet balance sheet funding needs through all market environments.
18
Crowded Financing Trade
Sources of securities
Sources of cash
Mutual Funds
SecuritiesLenders
Beneficial Owners/Bank Portfolios
Dealer Desks Direct
Customer Supply
Internal Dealer Cash
Securities Lenders Cash Reinvest
US Commercial Banks
Non-US Commercial Banks
Prime Brokers
Hedge FundHedge
FundHedge Fund
Hedge Fund
Hedge Fund
19
Treasury – Centralized Execution
Central Funding Approach
Assets are funded centrally through Treasury.
Close collaboration to determine the long term funding needs of the business.
Centralized funding through a diverse network of sources of cash and collateral.
Not reliant on PB model
Direct relationships with sources of cash and collateral
Longer term stable commitments
Started effort over 6 years ago
Sources of securities
Sources of cash
Mutual Funds
SecuritiesLenders
Beneficial Owners/Bank Portfolios
Dealer Desks Direct
Customer Supply
Internal Dealer Cash
Securities Lenders Cash Reinvest
US Commercial Banks
Non-US Commercial Banks
CITADELCITADEL
Prime Brokers
Centralized execution of secured funding provides substantial scalability and efficiency. It also allows PMs to focus on portfolio construction and Treasury specialists to focus on funding.
20
Funding Dislocation
Accelerated deleveraging on the back of the financial panic and forced liquidations by banks, hedge funds and other investors in Q3 and Q4
Severe dislocation in funding markets post Lehman bankruptcy driven by several factors
Inadequate funding models among firms taking term asset risk without term liability structure
Concerns around systemic risk in the banking system
Lenders became unwilling or restrictive in lending
• Multiple asset classes impacted, even in fully hedged assets
• Concerns around changing regulatory frameworks Implementation of short sale restrictions by regulators in several markets)
• Ability to liquidate or hedge collateral in a default as primary concern
Breakdown in the relationship between cash and derivative assets, notably in convertible and corporate bonds
21
Funding Dislocation
Citadel focus in Q3 and Q4
Holder of balance sheet assets in a period of unprecedented funding dislocation
Key Focus to maintain strong liquidity and capital position through utilization of management framework
• Reduction in size of balance sheet/risk broadly but maintain highest quality trades
• Refocus activities on skill based investment businesses
• Elimination of several balance sheet intensive businesses Reinsurance Fundamental Credit U.S. Power Trading
22
Estimated US Non-Financial Convertible Discount to Fair Value
-1.5
-0.5
0.5
1.5
2.5
3.5
4.5
5.5
6.5
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Edg
e (b
pt) .
5.6
The US Non-Financial Convertible Discount to Fair Value time-series represent the average US non-financial convertible bond discount to fair value, weighted by amount outstanding. For this purpose, the Merrill Lynch US Convertible Index is used to define the set of securities considered for inclusion. Convertible securities whose underlyings do not have exchange-traded options, exchangeable bonds, convertible preferred stock, and mandatorily convertible securities are excluded. The Citadel proprietary valuation model is used to estimate fair value. Citadel’s model is calibrated using US Credit, Equity, and Option market data from January 2003 to present. The Estimated US Non-Financial Convertible Discount to Fair Value time-series incorporates a combination of inputs designed to provide reasonable estimates of fair value. Individuals may disagree about the design of the framework as well as the inputs and assumptions made. The framework, inputs and assumptions may not be accurate, and the inputs will change over time. The actual discount to fair value may differ materially from the estimated fair values generated by the Citadel proprietary valuation model. Furthermore, there can be no assurance that market prices will converge to fair value over time.
January 1, 1998 to September 12, 2008
23
Estimated US Non-Financial Convertible Discount to Fair Value by Rating
Please see the end notes for important information about this presentation.
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr
Edg
e (b
pt) .
US - All Ratings
US - High Yield
US - Investment Grade
10.5
8.9
5.0
2004 2005 2006 2007 2008 2009
January 1, 2004 to April 6, 2009
24
Bond Basis Spreads
0
50
100
150
200
250
300
350
400
450
May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr
Spre
ad to
Lib
or .
Representative Bond Basis
Historical Data
2007 2008 2009
25
Funding Dislocation – The Road “Forward”
Recent Fed data indicates that total bank deposits were approximately $8.8 trillion versus $3.8 trillion in the money funds with growth rates of 5% and 23%, respectively, during 2008
Over half of money fund growth during Q4 2008
Effect of “breaking the buck”
Growth directed toward S/T Agency and Treasury securities as CP holdings and Repo holdings shrunk
• Repo market down over 30% in Q4 2008; almost 50% in the 2008
• Bank CP market shutdown even with government guarantee programs in place
• Highlights that money funds currently have little use in providing liquidity to the system
Increased importance of bank deposits in traditional mix of short term, medium term and long term secured and unsecured lending by banks for the foreseeable future
Will be constrained by leverage ratio/gross balance sheet concerns
Dysfunctional Funding Market Continues
26
End Notes
1. The US Non-Financial Convertible Discount to Fair Value time-series represent the average US non-financial convertible bond discount to fair value, weighted by amount outstanding. For this purpose, the Merrill Lynch US Convertible Index is used to define the set of securities considered for inclusion. Convertibles securities whose underlyings do not have exchange traded options, exchangeable bonds, convertible preferred stock, and mandatorily convertible securities are excluded. The Citadel proprietary valuation model is used to estimate fair value. Citadel’s model is calibrated using US Credit, Equity, and Option market data from January, 2003 to present.