What Did We Get Right, What Did We Get Wrong, and What Does the Future Hold ?

1. What Did We Get Right, What Did We Get Wrong, and What Does the Future Hold? San Diego, CA ~ April 29 & 30, 2009

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

3. Section 1.  What Did We 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

4. 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

5. 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)

6. 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

7. 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

8. LAW AND THE ECONOMY

9. 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

10. 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

11. 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??

12. A New Wave of Regulation? • Federal Reserve authority over any financial institution as a lender of last resort. • Increase Capital, Liquidity and Disclosure Requirements (“Transparency”). • Streamline Regulatory Structure (i.e., merge SEC and CTFC). • Regulate All Financial Institutions. • Limit aggressive trading/market manipulation. • Identify Systematic Risks to the Financial System (i.e., Financial Market Oversight Commission).

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

14. Who may be on the firing line of potential liability?

15. Litigation Statistics • 576 credit crisis/sub-prime mortgage related cases filed in 2008, an almost 100% increase in the number of cases filed in 2007. • About half of the cases filed in 2008 are before courts in New York and California. • 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.

16. More Litigation Statistics Six Major Categories of Litigation: • Borrower Class Actions • Securities Cases • Commercial Contract Disputes • Employment Class Actions • Bankruptcy-Related • All Other

17. 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.)

18. 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).

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

20. 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?

21. Lessons For the Future • Economy – Beware of the Other Shoe; history lessons from the Depression. • Legal – Follow Business Developments as Sources of Potential Litigation.

22. ACCOUNTING and GOVERNANCE RISKS

23. 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

24. 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

25. 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

26. 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

27. Identifying Risks in Financial Institutions- Scorecard on Financial Institutions, September 26, 2008

28. 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

29. Key Accounting Issues • Asset Valuation • Fair Value • Goodwill Impairments • Pension Plans • “Going Concern” opinions • Are companies going to stay in business?

30. 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

31. 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

32. 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

33. 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

34. 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 35

36. Financial Institutions Still at Risk As of April 13, 2009

37. Can We Trust the Watchdogs? • Exchanges, Rating Agencies have conflicts and credibility issues

38. 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

39. UNDERWRITING FINANCIAL INSTITUTIONS

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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.