October 19, 2009 Sacramento, CA

1. Public Pension Financial Forum Securities LendingThe Need for Risk Management October 19, 2009 Sacramento, CA Bo Abesamis Senior Vice President

2. Securities Lending • Securities lending is the market practice where securities are temporarily borrowed by one party (the borrower) from another party (the lender). • Borrowers tend to be hedge funds or other investors who need to cover a short position. • Securities are borrowed for a certain period of time and the borrower gives collateral in exchange for the securities. • Collateral generally consists of: • Cash • Government securities, or • Letters of credit • Revenue sharing percentages range from 50/50 for smaller programs to 90/10 for larger programs.

3. Securities Lending Explained (continued) • The collateral is invested in higher yielding securities that earn a premium to the income rebated to the borrower. • Security loans are collateralized at higher levels to compensate for fluctuating market values of the securities loaned. • Collateralization levels: • 102% for U.S. securities • 105% for non-U.S. securities • The loan’s value is marked to market on a daily basis and compared against the collateral. Additional collateral is posted if the loan to collateral value falls below pre-established values.

4. Securities Lending Basic Premise • Why Lend? Extra revenue or returns (often to cover administrative and custody costs). • What is it? Owner of a security agrees to lend the security to a borrower according to negotiated terms and the owner is secured with collateral. • Why Borrow? To make delivery of securities to avoid fails and money is not tied in the cash market. • Do you Own What You Lend? No, but you are entitled to the economic benefits of ownership, except for proxy voting. You receive collateral for the lent securities at 102% (Domestic) and 105% (Int’l). Collateral should at least be 100% all the time.

5. Regulatory Oversight • DoL PTE 81-6, PTE 82-63, Rule 15c3-3 and PTE 2006-16 (Party-in-Interest, Collateralization, etc.) • FFIEC (Agent Type Program) • SEC Limits and Borrower Behavior • FASB (Reporting & Acctg. for Leverage) • GASB (Reporting & Acctg. for Leverage) • IRC Section 1058 vs. 74-27 (Tax Issues) • Related – • SEC Reg SHO • SEC 204 and 204T • FASB Pronouncements Note: DoL PTE = Department of Labor Prohibited Transaction Exemption; FFIEC = Federal Financial Institute Examination Council; SEC = Securities & Exchange Commission; FASB = Financial Accounting Standards Board; GASB = Government Accounting Standards Board; and, IRC = Internal Revenue Code

6. Anatomy of a Loan

7. Rebate Rate – The Bogey

8. Lenders Public Pension Funds ERISA Plans Endowment/Foundations Central Banks Mutual Fund Companies Investment Managers Insurance Companies Taxable Accounts Borrowers Hedge Funds Prime Brokerage, Broker/Dealers Finance Inventory Trading Arbitrage Who are the Lenders and Borrowers?

9. Motivations for Borrowing Securities • Settlement Borrowing • Financing • Capital Markets and Securitization • Strategy Borrowing/Hedging • Arbitrage • Short Selling • Market-Neutral/Statistical Arbitrage • 130/30 Strategies • Merger Arbitrage • Convertible Arbitrage • Event Driven Arbitrage • Macro Arbitrage/Global Asset Allocators • Dividend/Tax Arbitrage • Borrowing to Facilitate Structuring (Structured Products, etc.) • Prime Brokerage

10. Risks • Borrower Risk • The risk that the borrower will not return the securities due to insolvency or for any other reason (e.g. loan recall for proxy voting or sale of security). • Collateral Reinvestment Risk • The risk that the investment of the cash collateral will not earn a sufficient return to cover the agreed upon rebate rate due to Interest Rate Risk, Liquidity Risk and Credit Risk. • The investor can stipulate the types of acceptable collateral and the instruments in which the collateral can be invested. • Operational Negligence • The risk that an agent fails to mark to market collateralization levels, posting of corporate actions and income, including all economic benefits of ownership except for proxy voting. • Trade Settlement Risk • The risk that an investor sells a security that is out on loan and that the loaned security is not returned by the borrower and that a trade fails or the seller is charged with an overdraft fee. • Country and Currency Risks • Political, Exchange Rate, Economic, Sovereign and Transfer Risks • Vigilance is the only real solution.

11. Cash Collateral Reinvestment

12. Liquidity Risk • The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. It tends to compound other risks – market risk, credit risk, etc. • Market liquidity risk is the risk that the market liquidity worsens when you need to trade. • Funding liquidity risk is the risk that a trader cannot fund his position and is forced to unwind. • Asset Liability Management, Scenario Testing, Stress Testing, etc.

13. Duration Mismatch • Many lenders utilize a duration mismatch – which combines the use of interest rate, credit, and liquidity risks – to enhance revenues. A duration mismatch occurs when the interest rate sensitivity of one side of the book (usually the assets) is longer than the interest rate sensitivity of the other side of the book (usually the liabilities). • If the cash collateral reinvestment is not able to cover that rapid reset to the new fed funds rate at the higher level, that’s when the possibility of a loss from duration mismatch can occur.

14. Securities Lending is NOT and NEVER will be Risk Free!