2009 Professional Risk 2009 Professional Risk Symposium: EPL, E&OSymposium: EPL, E&O

and Fiduciaryand Fiduciary

San Diego, CA ~ April 29 & 30, 2009

What Did We Get Right, What Did We Get Wrong, and What Does the

Future Hold?

WHAT DID WE GET RIGHT, WHAT DID WHAT DID WE GET RIGHT, WHAT DID WE GET WRONG, AND WHAT DOES THE WE GET WRONG, AND WHAT DOES THE

FUTURE HOLD?FUTURE HOLD?

MODERATOR:

Cary Meiners, Product Manager, Travelers

PANELISTS:

Raymond DeCarlo, MBA, CPCU, Senior Managing Director,

Frank Crystal & Company

Fred H. Knopf, Esq., Partner,

Wilson Elser Moskowitz Edelman & Dicker LLP

Jack Zwingli, MBA, Chief Executive Officer,

Audit Integrity

Section 1.  What Did We Section 1.  What Did We Get Right?Get Right?

• Our content on sub-prime lending was accurate and the worst case scenarios shared last year proved true

• The concern over rating tranches of CDOs was accurate and on point

• We also discussed, to a lesser degree, credit default swaps and correctly assessed their negative impact at a high level

• The development of litigation for E&O, fiduciary and D&O in the financial institution world also proved true

Section 2.  What Did We Get Wrong?

• We did not discuss the broader impact on the economy at length, including conventional mortgage defaults, general economic slowdown or the broad impact of credit tightening

• • The duration of the problem will probably

be even greater than was suggested

• Our projected number of bankruptcies for non-financial institutions was too low

Section 3.  What Does the Future Hold?

• The International Monetary Fund (IMF) estimates “toxic” assets to reach as high as $4 trillion: $3.1 trillion in the US, $900 billion in the EU & Asia.  If true, to date only 1/3 of that amount has actually been written off (about $1.29 trillion)

• There is a movement afoot to legislate and regulate derivatives more closely, as well as regulating securitization, which would greatly restrict its use (i.e., Barney Frank proposals)

Section 3.  What Does the Future Hold?

• Timeline of Bad Bank Debt from 2007-2009:   • First—Subprime Mortgages • Now:  Conventional Mortgages, Commercial Loans and Credit

Card defaults • FASB recently eased mark-to-market accounting rules which

may aid banks, but also delay taking hard write-offs • Ironically, bailed out banks are now considering purchasing

toxic assets from other banks• Non-investment grade default rate could exceed the rate of

the Great Depression (Moody’s projection is above 15% or higher)

• Credit card default rates now over 6% with some companies experiencing 8% or higher

Section 3.  What Does the Future Hold? (cont’d)

• Expected oversight of hedge funds.  Legislation entitled “Hedge Fund Transparency Act” will clearly cover things beyond hedge funds and include many private equity funds too.  U.S. Senators Levin and Grassley introduced this legislation. 

• Ratings agency Fitch has stated that no AAA rating will be given to companies with “financial oriented enterprises”  They recently downgraded Berkshire Hathaway. 

• Litigation of note that was dismissed:  Citigroup which invoked the Business Judgment Rule effectively

LAW

AND THE

ECONOMY

Economy: No End in Sight Yet

• Unemployment claims 2009 = 100% increase from April 2008.

• FDIC Bank Takeovers = 25 in 2008; 24 YTD for 2009. RBC analyst predicts 1000 failures in the next 3-5 years.

• Foreclosure filings Q1, 2009 = 803,489

Does History Repeat Itself??

• 1920s: Banking dominated by larger than life figures

who built giant financial empires; Bankers paid much more than counterparts in

other industries; Household Debt as % of GDP doubled between

the end of WWI and 1929; The Post-Depression Banking System was

highly regulated; Financial Markets were also highly regulated

(S.E.C., etc.)• 1940s-1970s: Spectacular Economic Progress

Does History Repeat Itself??

1980s – 2000s: Political Changes= Banking regulations were

gradually lifted; Debt rose rapidly- Aided by Tax Reform Act

(1986) – Reaching 1929 Levels by 2000; By 2005, the Financial Industry alone = 1/3 of all

Corporate Profits; Soaring incomes made Finance popular again; The Return of Regulation?? In What Form??

A New Wave of Regulation?

1. Federal Reserve authority over any financial institution as a lender of last resort.

2. Increase Capital, Liquidity and Disclosure Requirements (“Transparency”).

3. Streamline Regulatory Structure (i.e., merge SEC and CTFC).

4. Regulate All Financial Institutions.5. Limit aggressive trading/market manipulation.6. Identify Systematic Risks to the Financial System

(i.e., Financial Market Oversight Commission).

Off Balance Sheet Alphabet Soup: MBS, CDS, CDO …

Who may be on the firing line of potential liability?

Litigation Statistics

1. 576 credit crisis/sub-prime mortgage related cases filed in 2008, an almost 100% increase in the number of cases filed in 2007.

2. About half of the cases filed in 2008 are before courts in New York and California.

3. 69% of the 866 credit crisis/sub-prime mortgage related cases filed since January 2007 are active.

For comparison: 559 cases in total were filed by the RTC during the S&L crisis (1989-1995).

See Jeff Nielsen, Subprime Mortgage and Related Litigation 2008: Seeking Relief, Navigant Consulting, Mar. 2009.

More Litigation Statistics

Six Major Categories of Litigation:

1. Borrower Class Actions

2. Securities Cases

3. Commercial Contract Disputes

4. Employment Class Actions

5. Bankruptcy-Related

6. All Other

Litigation Developments

• 2/9/09: Dismissal Granted in Sub-Prime ERISA Action, re: Huntington Bancshares (S.D. Ohio)

• 2/11/09: Dismissal Denied in Sub-Prime ERISA Action, re: NovaStar Financial (W.D.Mo.)

• 2/12/09: $400 million Credit Suisse Auction Rate Securities Award.

• 3/30/09: Jury Trial Commences re: Jaffee Pension Plan v. HFC (N.D. Il.).

• 4/1/09: New Century Trustee v. KPMG – Two Gatekeeper Claims (LA Superior Court and S.D.N.Y.)

Litigation Lessons/Trends

• Georgia – The Bank Failure Capital of the World.

• Credit Card Litigation – “engaging in risky lending.”

• Bailout Lawsuits – failure to take proper advantage of available remedies (i.e., TARP).

Ponzi Scheme Cases

• Economic Conditions Frequently Give Rise to the Revelation of Frauds, which gives rise to Fraud-Based Litigation.

New to the Mix

• Specialty Property/Casualty Insurers Monoline Financial Guarantee Insurers –

Initially, insured municipal bonds, but expanded into insuring structured financial issues, like MBS, CMO and CDO.

Mortgage Guarantee Insurers – In 2007, eight insurance groups provided private mortgage insurance with premium of $6.2 billion.

• Hard Insurance Market?

Lessons For the Future

• Economy – Beware of the Other Shoe; history lessons from the Depression.

• Legal – Follow Business Developments as Sources of Potential Litigation.

ACCOUNTING

and

GOVERNANCE RISKS

Looking Back – November, 2007(cont’d)

FINANCIAL INSTITUTIONS AND DISCLOSURE Reliability and Reality of Disclosure

• “Marking to Myth” – Warren Buffett Availability of pricing – “way less than half” of

all exchange securities have available prices, Daniel Harris, Goldman, WSJ Oct-12-07

• This summer, >80% of mortgage bond investors had trouble getting prices from their dealers, WSJ Oct-12-07

• Bear Stearns: 63% of (bankrupt) fund’s net assets were fair valued by management, BusinessWeek Oct-22-07

Looking Back – November, 2007

(cont’d)

FINANCIAL INSTITUTIONS AND DISCLOSURE (cont’d)

• Big Baths, Cookie Jars and other creative accounting

FAS 159 Mulligan – sell losers, no hit to profits, then buy back

• “In the wrong hands, it’s a great concern” – Neri Bukspan, S&P, CFO.com May-8-07

Dealing with subprime assets – sell to hedge funds, move off books

Looking Back – November, 2007(cont’d)

FINANCIAL INSTITUTIONS AND DISCLOSURE Evaluating Risks in Financial Institution

Disclosure• The problem – if Merrill can’t figure out the

value of their holdings, neither can you• Those doing the valuations have a huge

conflict of interest Management has much greater latitude “Valuation specialists” are being paid by

the company• Assets will be overstated

Looking Back – November, 2007(cont’d)

FINANCIAL INSTITUTIONS AND DISCLOSURE

• The scope of the valuation work is immense Many types of assets and liabilities are

covered – several dozen opinions/statements/pronouncements/etc. from FASB, others

Fair Value can be elected on a contract by contract basis

• Virtual identical entities can take divergent measures

Identifying Risks in Financial Institutions

- Scorecard on Financial Institutions, September 26, 2008

Financial Institution Current Quarter 1 Quarter Prior 2 Quarters Prior 3 Quarters Prior AIG Very Aggressive Very Aggressive Very Aggressive AverageAMBAC Aggressive Aggressive Very Aggressive AggressiveBank of America Very Aggressive Very Aggressive Very Aggressive Very Aggressive Bear Stearns Not Rated Very Aggressive Very Aggressive Very AggressiveCitigroup Very Aggressive Very Aggressive Very Aggressive Very Aggressive Fannie Mae Average Average Not Rated Not RatedFreddie Mac Aggressive Very Aggressive Not Rated Not RatedGoldman Sachs Very Aggressive Very Aggressive Very Aggressive Very Aggressive JPMorgan Very Aggressive Very Aggressive Very Aggressive Very Aggressive Lehman Brothers Very Aggressive Very Aggressive Very Aggressive Very Aggressive MBIA Very Aggressive Very Aggressive Very Aggressive AggressiveMerrill Lynch Very Aggressive Very Aggressive Very Aggressive Very Aggressive Moody's Very Aggressive Very Aggressive Very Aggressive AggressiveMorgan Stanley Very Aggressive Very Aggressive Very Aggressive Very Aggressive State Street Very Aggressive Very Aggressive Very Aggressive AggressiveWachovia Very Aggressive Very Aggressive Aggressive AverageWashington Mutual Very Aggressive Very Aggressive Very Aggressive AggressiveWells Fargo Very Aggressive Very Aggressive Aggressive Aggressive

AGR Rating

What Does the Future Hold?

• Accounting and Governance Issues are of great importance to corporate stakeholders

• Management integrity is severely tarnished

• Regulators and others overseeing the market have credibility issues

Key Accounting Issues

• Asset Valuation Fair Value Goodwill Impairments Pension Plans

• “Going Concern” opinions Are companies going to stay in

business?

Key Accounting Issues

• Fair Value Subprime Crash Equity Loss Fair Value

Write-downs More Equity Loss FASB/PCAOB Intervention Fair Value Write-ups Equity Gains (?)

“Orderly” vs. “Distressed” transactions Still highly subjective, “lots of wiggle room” Lack of comparable data for analysis

Key Accounting Issues

• Goodwill Impairments Equity Loss Goodwill Impairments

(write-downs) Earnings Declines More Equity Loss

• Pension Plans Severe shortfall in pension assets Unknown exposure to risky investments,

hedge funds

Key Accounting Issues

• Going Concern opinions Auditors and corporations are under

increasing pressure from regulators• Push to look beyond the next 12 months

GM, others raising visibility of this issue• Forecasts call for a significant increase

• Ratings agencies are raising related concerns over bond defaults

Key Governance Issues

• Executive Compensation AIG, Merrill, etc., etc. = investor outrage Challenges to previously accepted “best

practices” that have led to excessive pay Activist shareholders taking a more vocal

and prominent role Linking compensation to both

performance and risk taking

Key Governance Issues

• Enhanced Disclosure Compensation Director qualifications Strategic decisions

• Director Accountability Managing risks Conflicts of interest Performance measures

35

Industries at Risk

• Recently highlighted industries, based on economic conditions Luxury Markets Travel & Leisure Real Estate & related

• Industry sectors indicating the greatest risk Technology Healthcare Consumer Cyclical

Financial Institutions Still at Risk

Current Rating As of Sept 2008 1 Quarter Prior 2 Quarters Prior 3 Quarters Prior AIG Very Aggressive Very Aggressive Very Aggressive Very Aggressive AverageAMBAC Very Aggressive Aggressive Aggressive Very Aggressive AggressiveBank of America Very Aggressive Very Aggressive Very Aggressive Very Aggressive Very Aggressive Bear Stearns Not Rated Very Aggressive Very Aggressive Very AggressiveCapital One Aggressive Aggressive Aggressive Very Aggressive AggressiveCitigroup Aggressive Very Aggressive Very Aggressive Very Aggressive Very Aggressive Fannie Mae Aggressive Average Average Not Rated Not RatedFreddie Mac Aggressive Aggressive Very Aggressive Not Rated Not RatedGoldman Sachs Aggressive Very Aggressive Very Aggressive Very Aggressive Very Aggressive JPMorgan Very Aggressive Very Aggressive Very Aggressive Very Aggressive Very Aggressive Lehman Brothers Very Aggressive Very Aggressive Very Aggressive Very Aggressive MBIA Very Aggressive Very Aggressive Very Aggressive Very Aggressive AggressiveMerrill Lynch Very Aggressive Very Aggressive Very Aggressive Very Aggressive Moody's Very Aggressive Very Aggressive Very Aggressive Very Aggressive AggressiveMorgan Stanley Very Aggressive Very Aggressive Very Aggressive Very Aggressive Very Aggressive State Street Aggressive Very Aggressive Very Aggressive Very Aggressive AggressiveWachovia Very Aggressive Very Aggressive Aggressive AverageWashington Mutual Average Very Aggressive Very Aggressive Very Aggressive AggressiveWells Fargo Very Aggressive Very Aggressive Very Aggressive Aggressive Aggressive

AGR RatingFinancial Institution

As of April 13, 2009As of April 13, 2009

Can We Trust the Watchdogs?

• Exchanges, Rating Agencies have conflicts and credibility issues

CME Group Very AggressiveIntercontinentalExchange Very AggressiveMcGraw-Hill (S&P) AverageMoody's Very AggressiveNASDAQ OMX Group Very AggressiveNYSE Euronext Aggressive

Exchanges/Quasi-regulators

Implications for Accounting and Governance Risks

• Investor/Regulatory response to market crash Review of accounting practices that may have

thrown gasoline on the fire• Will result in period of inconsistent data, uncertainty

• Fair Value, Goodwill Impairment, Pension Accounting

• Going Concern Opinions and Bankruptcy risk

Governance issues will be prominent• Compensation, Disclosure, Accountability

• Financial institutions, overseers still at risk

UNDERWRITING

FINANCIAL INSTITUTIONS

Financial Institutions – another anomaly

• 2001 - IPO allocations/Research Conflicts• 2002 - Scheme Liability (Enron, Worldcom)• 2003 - Mutual Fund (Market Timing)• 2004 - Insurance Industry Investigations• 2006 - Stock Options Backdating• 2008 – Sub-prime/Credit Crisis• 2009 - Madoff Scandal

Why are Financial Institutions Targeted?

• Interact with the customer in many ways

• May have a fiduciary duty due to Specialized knowledge Control/discretionary authority Length of relationship/exclusivity

Impact on FI D&O and E&O renewals

• Capacity is constrained, rates are increasing, and deductibles rising, reinsurance treaty implications.

• Underwriting questions center around: Financial Structure (leverage, debt maturities, refinance risk) Stock Price Performance Dividend Strategy (cut, suspend, stock dividend) Guidance revisions Executive Compensation, margin accounts, Rule 10b5(1) trading

plans Fund leverage Redemption activity, gates and suspensions Valuation of illiquid assets Due Diligence Process Custodial arrangements, separation of duties

Beyond the numbers

• “ I want to emphasize that the impetus for the run on Bear Stearns was in the first instance the result of a lack of confidence, not a lack of capital or liquidity”

- statement of Alan Schwartz, President and CEO of the Bear Stearns Companies Inc. before the U.S. Senate Banking Committee, April 3, 2008

Macro Trends

• 2006 and 2007 “vintage” securitizations performing poorly

• Ratio of housing prices to rents still high in Q3, 2008• Little in new real estate development• Bankruptcy filing by a large real estate company• M&A may be back

Change in control issues, proxy fights, unsolicited bids Can not know at the time of underwriting the risk how the

board will respond

Investment Management Case to Watch

• Jones v Harris Associates L.P. U.S. Supreme Court agreed to review 7th circuit

decision relating to allegations of excessive adviser fee structure under Section 36(b) of the Investment Company Act.

Prior standard generally was the “Gartenberg” test requiring plaintiff to show the fees had no reasonable relationship to the services rendered and were not negotiated at arms length.