Gerald A. Beeson

1
PRESENTATION TO Financial Institutions Risk
Management Conference
Future of Financial Innovation
Gerald A. Beeson April 14, 2008
2
Future of Financial Innovation
From Vantage Point of Market Participant

• 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

3
Derivatives Market
Market Participant Observations

• Risk is essential but it needs to be supported.
  Its 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

4
OTC Margin Dispute Trends Example
2008
2009
5
Commitment to Innovative Solutions
6
Impaired Securitization Markets
7
Shutdown of the Securitization Market
Market Participant Case Study

• 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

8
Alignment of Interest
Pro Forma Cedants Exposure

• 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

Limits Written
Cedant Retention
1,200mm/P(E) 0.2 bps
Term Loan A
1,015mm/P(A) 0.7 bps
Term Loan B
875mm/P(A) 15.6 bps
710mm/P(A) 90.4 bps
Term Loan C
Net Losses
Term Loan D
650mm/P(A) 140.0 bps
Cedant Retention
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Risk Exposure
All Peril Occurrence PMLs
Analysis of the pro forma portfolio for calendar
year 2007 illustrates per occurrence PMLs
1,200
Term Loan A Exhaustion
1,050
Term Loan A Attachment
875
Term Loan B Attachment
710
Term Loan C Attachment
650
Term Loan D Attachment
Note MPCI and property per risk are not included
in the above analysis.
10
Low Probability of Loss Impact
Remodeled Key Historical Events1
1,200
Term Loan A Exhaustion
1,050
Term Loan A Attachment
875
Term Loan B Attachment
710
Term Loan C Attachment
650
Term Loan D Attachment

• 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.
• Katrina does not include marine gulf or flood.

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Projected Earnings Distribution (Combined
Gross/Net)
Projected Earnings Distribution as of 1/1/08
400
200
-
Total Gross of Emerson
Earnings (m)
(200)
Total Net of Emerson
(400)
(600)
(800)
50
55
60
65
70
75
80
85
90
95
100
Cumulative Probability
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Final Analysis
Q4 2008 Considerations

• Cost of capital
• Capital structure 75 equity and 25 debt
• Debt layer was 3 year term structure at L100 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

13
Funding Markets

• View from the Eye of the Storm

14
Business Architecture
Citadel Investment Group
Asset Management
Capital Markets
Alternative Asset Management
Market Making / High Frequency Trading
Citadel 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

15
Citadel Derivatives Group LLC
A Market Leader in Equities and OptionsEmbracing
disruptive technologies to improve liquidity
and transparency in the capital markets
8 of US Equity Volume
29 of US Options Volume
Sept 2008 data
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End of an Era
Disappearance of the Shadow Banking System
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Treasury Liquidity Management Philosophy
Ensure the provision of adequate liquidity to
meet balance sheet funding needs through all
market environments.

• Liquidity Reserve
• Maintenance of a pre-funded liquidity reserve to
  meet contingent cash needs of Citadels balance
  sheet

• 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 Citadels ability to
  reduce risk positions

• Liquidity Management
• Model Citadels 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

• 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

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Crowded Financing Trade
Sources of securities
Sources of cash
Mutual Funds
Customer Supply
SecuritiesLenders
Internal Dealer Cash
Beneficial Owners/Bank Portfolios
Securities Lenders Cash Reinvest
Dealer Desks Direct
US Commercial Banks
Non-US Commercial Banks
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Treasury Centralized Execution
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.

• 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
Customer Supply
SecuritiesLenders
Internal Dealer Cash
Prime Brokers
Beneficial Owners/Bank Portfolios
Securities Lenders Cash Reinvest
Dealer Desks Direct
US Commercial Banks
Non-US Commercial Banks
CITADEL
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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
January 1, 1998 to September 12, 2008
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.
Citadels 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.
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Estimated US Non-Financial Convertible Discount
to Fair Value by Rating
January 1, 2004 to April 6, 2009
10.5
8.9
5.0
2004
2005
2006
2007
2008
2009
Please see the end notes for important
information about this presentation.
24
Bond Basis Spreads
Historical Data
2007
2008
2009
25
Funding Dislocation The Road Forward
Dysfunctional Funding Market Continues

• 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

26
End Notes

• 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.
  Citadels model is calibrated using US Credit,
  Equity, and Option market data from January, 2003
  to present.