Toomre Capital Markets LLC

The Stamford, Connecticut chapter of the Professional Risk Managers' International Association ("PRMIA") held a very informative meeting on Wednesday, November 7th 2007 entitled "The Emperors' New Clothes?: After the Credit Crunch, What's the Future of Structured Credit, Financial Guarantors and Rating Agencies". Toomre Capital Markets LLC ("TCM") thought this was one of the most informative industry events yet and strongly recommends that the reader pay close attention to the incestuous circle of structured credit, financial guarantors and rating agencies. The speakers were:

• James Chanos – Managing Partner, Kynikos Assocaiates
• William Ackman – Managing Member, Pershing Sqaure Capital
• Edward Grebeck – CEO, Tempus Advisors

Some readers no doubt will recognize James Chanos and his fund Kynikos Associates as one of the most prominent short-seller hedge funds. Bill Ackman and his hedge fund Pershing Square Capital are primarily focused on the long side, but does have substantial short interest in the financial institution, rating agency and financial guarantor sectors. Bill is perhaps most well known for his excellent (and very negative) research report on MBIA from several years ago. The FORTUNE magazine article from May 16, 2005 entitled The Mystery of The $890 Billion Insurer has more information.

During the trading hours of November 7th, equities in the financial sector were under considerable pressure. This pressure is primarily tied to the great uncertainty about just what are Collateralized Debt Obligations worth, where the resulting large losses are buried and what are the secondary repercussions of the sub-prime meltdown, such as SIVs, option ARMs, and commercial mortgage credit-worthiness. After the close, American International Group ("AIG") reported 3rd quarter results that fell short of expectations primarily due to their losses from the mortgage markets. Then, Morgan Stanley ("MS") pre-announced that it be taking a $3.7 billion in losses in its proprietary trading businesses tied to principal investments in CDOs and other sub-prime mortgage-backed securities. (This amount may change over the balance of November until the end of Morgan Stanley's year end.)

Against this backdrop, James Chanos and William Ackman suggested that the markets are still in the early innings of this mortgage credit crunch process. Whereas some analysts have been suggesting as many as 1.5 to 2.0 million families may lose their residencies due to foreclosure in this mortgage credit cycle, their collective view is that the base level of foreclosures will be much worse, perhaps approaching 3.5 million or even 4.0 million incidents. They suggested that the collective market does not yet appreciate that things could get that bad nor have financial professionals begun to fully appreciate some of the national political repercussions of so many people losing their homes.

Reuters is reporting the obvious on Monday, November 5th, 2007: Cantor CEO says big CDO market has shut down. Apparently Cantor Fitzgerald LP Chairman and Chief Executive Howard Lutnick publicly has stated what Toomre Capital Markets LLC ("TCM") and many others have been saying for several weeks now: There are effectively no buyers and what people and organizations own on their books in CDO format, sub-prime mortgage format or just as general collateral has one place to go: DOWN.

The complete CDO market seizure means that there still are tremendous losses to come for those financial intermediaries that retained CDO bond classes, those investment portfolios that invested in them and, perhaps most importantly, all of those organizations that put on CDO "arbitrage" strategies. Perhaps people have not fully appreciated the full impact of this credit crisis? Maybe $25 Billion of the originally estimated $100 Billion dollars in losses have been reported by investment banks and global banking institutions. Where is that $75 Billion in other losses lurking? And assumes that the original $100 Billion number was even conservative enough… Some are already speculating that the total losses from CDO investments may total more than $250 Billion.

"The big CDO market is gone," Lutnick told the Reuters Finance Summit. "You'll see all the banks step out of it because they just can't do (the deals anymore) because they won't be able to churn them out to the buyers because the buyers are gone." Lutnick, whose firm controls one of the world's largest bond brokerages, said the easy buyers of CDOs have left the market. That leaves what he described as sophisticated buyers, who are willing to do their own math and find their own value for distressed CDOs. That will spawn a market for packaging the securities in a way that appeals to those investors, Lutnick said.

"The (CDO) repackaging business will be there, and it will grow enormously," Lutnick said. "No one is going to believe anybody anymore (about CDOs)," Lutnick said. "It's not just about the rating. You have to run your own math and come to your own view."

Toomre Capital Markets LLC ("TCM") would like to highlight a couple of items from UBS's 3rd quarter 2007 earnings report that was released on Tuesday, October 30th, 2007. Buried in the earnings report (a copy of the pdf file is attached to the bottom of this posting) is a discussion about the investment bank's market risk. The report states that "Investment Bank Value at Risk ["VaR"] (VaR-10-day, 99% confidence based on 5 years of historical data) ended the quarter at CHF 676 million, up from CHF 454 million at the end of the prior period end." Apparently the approximately 49% increase in VaR during the 3rd quarter was driven primarily by increased market volatility. As the report states, "The largest contributor to Investment Bank VaR at quarter end was credit spread on mortgage-related positions."

The earnings report continues with "'Backtesting' compares 1-day VaR calculated on positions at the close of each business day with the revenues arising from those positions on the following business day (excluding intraday trading revenues, fees and commissions)… When backtesting revenues are negative and greater than the previous day's VaR, a 'backtesting exception' occurs." The report then makes the rather startling admission: "In the third quarter [of 2007] we suffered our first backtesting exceptions in total – 16 in total – since 1988."

That is right folks! UBS's investment banking unit had losses on 16 days [Yes that is right sixteen days!!!] of the third quarter that it exceeded the Value-at-Risk calculated by its own risk management function. As an M.I.T.-trained engineer and the son of a mathematics professor no less, Lars Toomre is a little fuzzy with statistics and math. However, 16 out of 63 third-quarter 2007 trading days does make it seem like the losses at UBS exceeded it supposed daily VaR 25.3968% of the time!!!

Under a normal Gaussian distribution (bell-shaped statistical curve fitting that many are familiar with), a 99th percentile event is some 2.58 standard deviation units from the mean measurement and is meant to represent extremely unlikely events. In insurance terms, the 99th confidence interval is often used to represent that realized losses from all events but that single extremely unusual one in a hundred year event will be less than the stated amount. UBS' VaR modeling did not even capture greater than one standard deviation events (i.e. less than 84.13% of the time).

Clearly, UBS' realized experience during the 3rd quarter of 2007 greatly exceeded the losses that they estimated would occur only 1% of the time. Some of this variation no doubt can be attributed to the sharp pick up in volatility, and particularly in the seemingly one-way movement of sub-prime mortgage and other structured finance securities. And yes, some market sectors did have an almost step like decline in valuations. However, Toomre Capital Markets would suggest that the volatility in structured finance prices already was increasing in both the first and second quarters. Did not the UBS security prices reflect the sharp declines in the various ABX indices that started in the fourth quarter of 2006? Why were there no backtesting exceptions during earlier accounting periods?

So while several of the 'backtesting exception' days can be excused, an outside observer might be very accurate in observing that either the risk management process itself and/or the data feeding it was flawed, or more likely, UBS had extremely concentrated positions that declined in value relative to the historical volatility of their prices.

Toomre Capital Markets LLC ("TCM") provides advisory services to firms either engaged in or providing technology to the financial services industry. Our specialties include applying emerging technology and innovative ideas to the broad field of Enterprise Risk Management ("ERM"). We assist these clients with implementing and marketing innovative solutions to the problems and opportunities that today's financial services firms and their customers confront.

As part of our services, TCM consults closely with Advanced Micro Devices, providing subject matter expertise on the capital markets, structured finance and risk management. Another example of our work is a newly released white paper entitled "Operational Risk" that TCM wrote on behalf of AMD. We encourage the reader to review this white paper and to contact AMD or TCM to discuss thoughts and possible applications or consulting engagements.

Since the note White Paper: "Market Risk and Algorithmic Trading" was posted, there has been considerable web traffic looking for further information on either algorithmic trading or the topic of enterprise risk management ("ERM") in general. Partly as a result, TCM has been asked to create a posting with links to each of the white papers TCM has written on behalf of this technology client. These white papers include:

• The Future of Real-Time Enterprise Risk Management ("ERM")
• Driving Value in Credit Products
• Adopting a New Standard for ERM in the Energy Sector
• Market Risk and Algorithmic Trading
• And coming shortly… Operational Risk Management