Link >>> RBS Defence Statement (Amended)

Paragraph 204

The most relevant structured-credit experts were the ABS CDO traders, Fred Matera and Evan
Gerhard, who sought substantial markdowns, which Victor Hong independently corroborated.
The RBS senior managers who overrode their special expertise were not formally qualified as
ABS CDO traders or market experts.

In late 2007, RBS bought the junior-senior tranche of the CRNMZ 2007-3A subprime ABS CDO at
23:00, while owning its super-senior tranche near 90:00. The ABS CDO traders determined that
the latter tranche was hence over-marked, and unsuccessfully urged Joseph Walsh to allow
markdown. This was an example of RBS-observed market trading prices, which contradicted the
disclaimers of Carol Mathis and Lauren Rieder on their Witness Statement and IPV Reports,
respectively, about no market trades to justify markdowns. Both the junior-senior and super-
senior tranches of the CRNMZ 2007-3A CDO deal were downgraded from "AAA" to junk credit
rating in early 2008 and then defaulted, confirming that the super-senior tranche needed
substantial markdown, given the observed trade of the junior-senior tranche.

Paragraph 205A, B, F, G, H

RBS used two approaches for the "Fundamental Value" of an ABS CDO:

1. Discounted CashFlow (DCF): Project its underlying RMBS cashflows with the LSD credit
model and discount them to Present Value. RBS deemed the LSD model as flawed or
outright invalid, but still applied it.
2. Net Asset Value (NAV): Sum the market liquidation values of those RMBS, as if the ABS
CDO deal were dissolved. RBS assumed above-market RMBS sale prices here ("make-up"
per 2 November 2007 Bruce Jin e-mail).

Either way, Fundamental Value, as RBS practiced it, would materially exceed Fair-Market Value.
It meant using a flawed internal model or off-market inputs, to produce an above-market price.
This is impermissible Mark to Model, not Mark to Market as required.

These RBS officials deemed the LSD model as flawed or invalid, by over-predicting RMBS
principal and interest cashflows and under-predicting borrower default losses:

ABS CDO traders, Fred Matera and Evan Gerhard (12 and 15 October 2007 e-mails)
CEO Fred Goodwin and Finance Director Chris Kyle (20 November 2007 e-mail)
Riccardo Rebonato (25 July 2007 and 29 October 2007 e-mails)
Carol Mathis (30 October 2007 Senior Management Valuation Control and Reserves
Meeting minutes; and 15 April 2015 Carol Mathis Witness Statement, Paragraph 15)
John Cameron (29 October 2007 e-mail)
Bruce Jin (29 October 2007 e-mail)
QuaRC model validation group (Dherminder Kainth).

Under the FASB/IFRS Fair-Valuation Hierarchy, if a company switches from Mark to Market, using
observable market inputs, to Mark to Model, using non-observable, off-market, or judgmental
inputs, it must re-classify the affected assets from Level 1 or Level 2, to Level 3 instead, AND
disclose publicly to investors and regulators.

http://www.fasb.org/summary/stsum157.shtml
http://www.iasplus.com/en/standards/ifrs/ifrs13
https://en.wikipedia.org/wiki/Mark-to-market_accounting
http://www.pwc.com/us/en/cfodirect/assets/pdf/accounting-guides/pwc-fair-value-measurement-2015.pdf

RBS never disclosed the non-market, Mark-to-Model valuation of the ABS CDOs, or their above-
market NAV analysis, in 2007 or before its 2008 Shareholder Rights sale. Accounting rules do
not allow reporting a Mark-to-Model price as a Mark-to-Market price, regardless if any non-
market, judgmental "buffer" is also applied for calculation.

Trading-book assets must be marked daily to observable fair-market value. US/UK accounting
rules and US Sarbanes-Oxley Act forbid senior management to impede this requirement, where
company financial, regulatory, and security-issuance disclosures report that trading-book assets
are marked to fair-market value. Accordingly, the RBS Greenwich IPV policy (U.S. Structured
Credit Markets Independent Valuation Compliance Statement) required Bruce Jin and Lauren
Rieder monthly sign-off attestation:

"I acknowledge that traders are responsible for ensuring that their positions are correctly
marked to market and that trader supervision by Front Office management provides the
primary control over the accuracy of these marks."

Suppose if the LSD model projected RMBS cashflows with perfect accuracy. Discounting such
cashflows to Present Value, via a non-market interest rate, in order to calculate an ABS CDO
price exceeding observable Fair-Market Value, would still violate accounting and regulatory
rules.

On 20 November 2007 e-mail, Chris Kyle told Carol Mathis that CEO Fred Goodwin believed that
ABS CDO market pricing "is way ahead of itself", reflecting distressed sellers. Kyle stated that
RBS was not a distressed seller, and would mark its portfolio at LSD-modeled prices (regardless
of flawed model), not at prevailing fair-market prices. In its 2007 public financial and regulatory
statements, and its 2008 Rights offering, RBS stated contrarily that its ABS CDO trading portfolio
was marked to prevailing fair market, not to internal model. Sarbanes-Oxley Act and US/UK
accounting standards required that trading-book positions be marked to market, per observable,
reliable trading data.

Paragraphs 205Q, R, S

RBS was a contributor of subprime RMBS price quotes for the Markit ABX indices:

If RBS price quotes for these subprime RMBS were falling as steeply as the ABX indices,
that might evidence that RBS knew that its subprime-backed ABS CDOs were falling
similarly in NAV, and thereby was intentionally and substantially over-marking them.
If the RBS price quotes were falling much less than the ABX, that might evidence that RBS
intentionally contributed above-market quotes for benchmark index calculation. If so, this
would resemble the off-market interest rate and currency quotes which many banks had
contributed to LIBOR and FX benchmarks, respectively.
Paragraph 205V, W, Y, AM

The RBS QuaRC model-validation team, when invalidating the LSD model, projected that the ABS
CDO portfolio would be "100% written off at 36 months", which has generally proved true.

On 25 July 2007 e-mail to Brian Crowe, Riccardo Rebonato noted that ACA Financial might
renege on its credit insurance guarantee of the defaulting ACA 2007-1 CDO super-senior
tranche, which might then force RBS to take back its risk and book a $1.5 billion total principal
loss. RBS failed to book a 2007 loss reserve for this known counterparty credit risk, as US and
UK regulations required.

Victor Hong can attest that senior management impeded the trader marking of ABS CDOs per
observable fair-market value, and the independent reporting of substantiated price-verification
variances. Proper segregation of duties means that:

traders mark their trading books daily to fair-market value

Independent Price Verification validates those marks via observable, reliable market data
senior management resolves material price-testing variances.

US/UK regulators and RBS policies require that independent groups separately perform the
portfolio marking and price-verification duties, for best-practice risk control. Instead, RBS
senior management undertook both duties, in order to override the separate but consistent
recommendations of ABS CDO Head Trader Fred Matera and IPV Head Victor Hong. Victor Hong
can attest that both resigned constructively in protest.

RBS described that Victor Hong delivered an "unstructured provision of press reports, research
notes and market information relating to the valuation of SS CDOs held by other institutions".
RBS indicated that Victor Hong did not provide meaningful price-verification analysis to justify
his writedown requests. This was the 2007 ABS CDO market information which RBS
claimed to be non-existent, unreliable, or not provided. Such consisted of:

credible ABS CDO dealer offering quotes, NAV calculations, and prepayment/default
research
reliable subprime RMBS price quotes
independent credit-rating agency analysis of ABS CDO default risk
publicly reported ABS CDO writedowns at other global banks.

___________________________________________________________________

On 14 November 2007 e-mail, Carol Mathis notified John Cameron, Chris Kyle, and Jay Levine
about foreseeable RBS failure, per discussion with Guy Whittaker. Mathis stated the need to
recapitalize RBS, and the risk of incapacitated funding (bank run), if writedowns are incurred, by
marking ABS CDOs to market instead of the LSD model.

In 2007, ABN Amro internal auditors found that the ABN Amro structured-credit traders were
improperly modeling and marking approximately $35 billion of ABS CDOs and non-agency RMBS.
The traders and the Finance Director then departed
(http://dealbook.nytimes.com/2007/05/10/abn-amro-cfo-resigns/). This would indicate that ABN
Amro and RBS, via merger due diligence, understood that both their ABS CDO portfolios were
marked substantially above fair-market value. Please obtain and refer to that internal audit
report.