INTEREST RATE RISK #
The Savings and Loan Crisis
S&L prospered using riding yield curve in 20th century. However, rising inﬂation in late 1970s prompted the Fed to implement restrictive monitory policy, resulted in signiﬁcant increase in short term interest rates. Outcome was increased negative mar-gins of many of their long term residential mortgage portfolios.
The failure in S&L to manage their interest rate risk helped to spark a long running crisis in the US. Entity tried to re-pair their balance sheet with new business activities and higher margin riskier lending. This resulted in industry loosing more money.
Between 1986 to 1995 many S&Ls failed or were taken over. The remaining eventually failed. The crisis necessitated what was one of the world’s most expensive banking system bailouts. USD 160 Billion bailout was funded by the American Taxpayers.
Bank invested heavily in the securitized US real estate market by selling mortgage to residential customers, turned these loans into securities and then sold these to investors. When the real estate market collapsed, bank continued to build up its real estate securitization business. Bank was highly leveraged and had Asset to equity ratio of 31:1. Mean during the real estate market fall, bank began borrowing short term to fund long term assets. During 2007, when it became evident that the US housing bubble had burst, confidence of short term lenders erode. Banks major counterparties began demanding more collateral while other began reducing exposure.
Attempt to rescue or to sell the ﬁrm to another large bank ultimately failed. On 15th Sept 2008, Leahman was forced to ﬁle for bank-ruptcy, inciting months of panic and uncertainty in the global ﬁnancial markets.
LIQUIDITY RISK #
Continental was once largest bank in Chicago. Starting in the late 1970s, the bank was pursuing an aggressive growth strategy that resulted in 3 times jump in lending business in 5 years.
First sign of ﬁrms problem surfaced when, Penn Square Bank which was smaller bank issuing loans to oil and natural gas companies became insolvent. Penn being relative-ly smaller bank, if the loan was too large for it to service, it would pass it to big banks like Continental. Due to failure of Penn, Continental faced heavy losses as default rose.
When Continental found itself unable to fund its operations from the US market, bank started to raise money at higher rate from foreign wholesale money markets.
When the rumors about Continental worsening ﬁnancial condition spooked the international markets, foreign investors began to withdraw their deposits ($6 Billion in only ten days). To prevent domino effect, regulators stepped in and bailed out by capital injection and payout to depositors.
Liquidity risk from Internal credit portfolio problems.
UK based bank had been growing assets at 20% per year for several years by specializing in residential mortgagees and continued to do so into the ﬁrst quarter of 2007. Bank relied on originate to distribute model hence relied less on the retail depositors. Bank in order to manage risk diversiﬁed geographically. In 2007 crisis spread globally to ABS as an investment class, then to the institutions that invested in it and eventually in interbank markets. Interbank funding market froze in mid 2007, resulting in all of North-ern rocks funding channels seized up simultaneously. Ironically, earlier in summer bank increased interim dividends and regulators ap-proved a Basel II waiver and allowed to go for Advanced approach for credit capital.
When bank was unable to fund itself in interbank markets, regulators intervened. Plan of Bank of England’s planned support leaked, resulting in run on deposits in mid Sept 07. Northern Rock eventually accepted emergency government support and then public ownership.
Liquidity risk arising from structural weakness in banks business model.
HEDGING STRATEGY #
MGRM subsy of MG offered customer to buy heating oil and gasoline at ﬁxed amount of $5 per barrel. Over 5 tor 10 year period. This position equivalent to short call and this position was hedged by long position in near term future using stack and roll strategy. When markets plunged MGRM re-quired to pay margin but gain on the same were supposed to generate from receipts of oil sell. This strategy is sound on paper but created cash crunch for MGRM. This type of situation can be corrected by borrowing cash for short time period but due to downgrade in credit rating borrowing was not possible. MGRM had little equity to sustain this. Short Call (equivalent):- MGRM offered customers to buy oil and gasoline at ﬁxed rate. With the option to exit the contract if spot price rose above ﬁxed price and MGRM would pay half/ full difference of spot and ﬁxed price. This can be exercised by buyer in case she is no more need of the product.
When the oil priced dipped, MGRM was required to pay margin on futures. This loss was recoverable from sell of oil at fixed price buy in long term. As per accounting rules MGRM reported losses on futures but was not allowed to account for gain on short call. Due to this reporting loss MGRM rating were downgraded and firm was unable to borrow funds repair current cash crunch situation. Also exchange increased margin requirements for the firm due to loss of confidence. The problem was not hedging strategy but the conservative accounting police. Was also subject to liquidity risk.
MODEL RISK #
Victor Neiderhoffer was hedge fund trader. He developed strategy to harvest put option premiums by writing large quantity of OTM puts on S&Ps. As long as daily drop in index was less than 5% he would capture small premiums offered by these OTM puts. In 1997 markets crashed by 7% and result was $50M margin call which he was unable to meet.
His fund brokers liquidated all contracts, which wiped out the entire funds equity position. The lesson to be learned that assumptions can be ﬂawed.
JP Morgan tasked its CIO with managing $350B in excess demand deposits. It used money to make massive bets on synthetic credit derivatives which resulted in disaster for bank. When bank realized that it needed to reduce risk in or-der to satisfy regulatory capital requirements, instead of closing its short bets it entered into long to offset. This increased exposure of the bank.
When losses occurred in CIO strategies, rather than adjusting economic impact of the trades leadership decided to adjust the valuation methodology. When these discrepancies came into light deputy CRO asked to reinstate the valuation methodology result-ed in both economic and ac-counting losses.
Throughout this time line, the CIO was routinely breaching internally established risk limits. Ultimately cost bank $6.2b in trading losses and temporarily disrupted global markets.
In 1995 some of the most brilliant minds in ﬁnance of that time started fund and gathered capital from investors. Fund kept position secret and investors were locked for long time period to prevent liquidation issues. Believing there success of trading strategies partners also invested substantial net worth in funds. Fund was highly leveraged with 28:1 ratio, amounting to $125B of asset on $4.7 B of equity which was in line, however economic leverage was above $1 trillion notional value. Other ﬁrms started to imitate LTCM, later LTCM realized that it is market maker. Due to reputation of ﬁrm no/less margin requirements were placed on the ﬁrm. Firms strategies mainly involved relative value, credit spreads and equity volatility. When implied volatility was high ﬁrm sold volatility until it dropped to normal levels.
Lessons learned from this case study: 1) Monitoring correlations—Even with the diversiﬁcation correlations might change in extreme events which must be monitored. 2) Watch liquidity: – Due to leverage LTCM was able to take large position. When it became necessary to liquidate these positions, LTCM found itself competing for market liquidity with imitators who were also liquidating their positions. 3) consider Loss Assumptions:- LTCM used 10 day vaR which was not suﬃcient to cover short term shocks. Stress testing is better. 4) Enhance Disclosure: LTCM was hedge fund hence was not subjected to disclosure. 5) Requirement of margin posting without exception.
One of the fundamental risk faced by ﬁrm was model risk of valuation models and trading models are ﬂawed. Models assumed historical relationships for future which is not true in economic shocks. In 1998 Russian default on debt start-ed chain of sequence increased frequency of shock events and models fall apart. Due to initial losses ﬁrm was forced to liquidation which created more MTM and margin calls this resulted into self reinforcing cycle. Ultimately Fed bailed out. Suggestions: 1) Initial margin must be provided 2) incorporate potential liquidation cost into prices 3) Bet-ter utilization of stress testing when evaluating ﬁnancial risks.
ROGUE TRADING #
Nick Leeson, Who was trading head of SG ﬂoor in order to recoup prior trading losses, took speculative derivative position to cover those losses. Which eventually resulted into more losses. Total loss-es $1.2 Billion. He was also back oﬃce head using his Authority to hide his position from London oﬃce. Short straddle on Nikkei 225 & Double Long Futures positions were taken.
Believing this strategy is riskless London oﬃce provided $354M as margin requirement. He used Authority in back oﬃce settlement operations helped him to hide these positions. He even got Bonus of $720000.
This is case of failed information reporting and control system. Lack of risk management oversight. No separation in trading and settlement responsibilities were present. Baring faced bankruptcy.
FINANCIAL ENGINEERING (COMPLEX DERIVATIVES) #
BT was known to be skilled risk manager. For this reason Proc-tor & Gamble approached BT to help manage interest rate risk. BT and P&G entered into swap where BT would pay ﬁxed rate in return for ﬂoating (Sold by misleading P&G). Fed started to raise interest rates, this change cost P&G a substantial sum and leverage ampliﬁed the losses. P&G sued BT and won case. Other ﬁrms had similar experiences.
BT faced reputation loss and eventually acquired by Deutsche Bank.
California’s orange coun-ty had $7.7B in assets and its treasurer, used short term repos to borrow an additional $12.9B, which was subsequently invested into complex inverse ﬂoating rate notes (FRN). In in-verse FRN coupon de-cline when interest rate increases. Initially Citron (treasurer) earned 2% higher return but when Fed increased interest rates strategy fell apart when investor did not roll over repos when coupons declined.
Citron later admitted that he really did not understand the risk exposures of inverse ﬂoaters. The lesson is to not invest in any-thing you do not understand because the losses can be terminal.
Landesbanks are series of public banks in Germany . In 2000 when Landesbanks saw proﬁt potential in US subprime market, it started to create off B/S entity and bought large subprime assets.
When the crisis struck Sachen sustained such heavy losses that it had to sell itself to another German bank.
CORPORATE GOVERN- #
Enron was in gas broking. Enron would purchase gas from various vendors and sell it to net-work of customers at predetermined prices. In Dec 2001, be-came the largest bankruptcy in US history. Various failures are
- Agency Risk: Management put self interest above other stakeholders by pursuing short term proﬁtability to maximize personal wealth and sacriﬁced the entire ﬁrm in the process.
- Accounting Fraud: used SPVs and accounting techniques (MTM) to commit fraud.
- Lack of Board Oversight:
- Revenue recognition practices:
- Auditor Failure: Arthur Anderson was sole auditor and was implicit in this fraud.
As a result of this crisis fueled need to bring Sarbanes Oxley (SOX) in 2002. this law requires accountability for key corporate oﬃcers relative to the reliability of reported ﬁnancial statement. It also created the public company accounting oversight board (PCAOB)., which holistically promotes a high standard for corporate governance.
In 2015 US Environment al protection Agency announced that VW had been unethical in its environmental responsibilities. It violated the ESG (Environmental, Social and Governance) ethos by programming the software on its vehicles to only control emissions during regulatory tests. Misusing this it sold 10M cars worldwide.
This damaged the reputation of VW.
VW faced billions of ﬁnes and decrease in sale as customers started to switch brand loyalty due to this scandal.
CYBER RISK #
The SWIFT Case
The Society for World-wide Interbank Financial Telecommunication (SWIFT) is the global leader in electronically transferring funds be-tween ﬁnancial institutions. In Feb 2016, hackers accessed the SWIFT system and stole $81B from the Bangladesh Bank. The access was through the use of employee credentials and series of requests to transfer funds to various locations through-out Asia. Bank of NY stopped all transfers after discovering a typo in one request . After money was transferred to Bank of Philippines. Hackers used malware to delete the record of the transfer and disable transaction conﬁrmation notiﬁcation.
Money was never re-covered because it was transferred from the bank in the Philippines to series of casinos and promptly withdrawn.