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In 1994, John Meriwether, the famed Salomon Brothers bond trader, founded a hedge fund called Long-Term Capital

Management. Meriwether assembled an all-star team of traders and academics in an attempt to create a fund that would profit from the combination of the academics' quantitative models and the traders' market judgement and execution capabilities. Sophisticated investors, including many large investment banks, flocked to the fund, investing $1.3 billion at inception. But four years later, at the end of September 1998, the fund had lost substantial amounts of the investors' equity capital and was teetering on the brink of default. To avoid the threat of a systemic crisis in the world financial system, the Federal Reserve orchestrated a $3.5 billion rescue package from leading U.S. investment and commercial banks. In exchange the participants received 90% of LTCM's equity. The lessons to be learned from this crisis are: Market values matter for leveraged portfolios; Liquidity itself is a risk factor; Models must be stress-tested and combined with judgement; and Financial institutions should aggregate exposures to common risk factors.

LTCM seemed destined for success. After all, it had John Meriwether, the famed bond trader from Salomon Brothers, at its helm. Also on board were Nobel-prize winning economists Myron Scholes and Robert Merton, as well as David Mullins, a former vice-chairman of the Federal Reserve Board who had quit his job to become a partner at LTCM. These credentials convinced 80 founding investors to pony up the minimum investment of $10 million apiece, including Bear Sterns President James Cayne and his deputy. Merrill Lynch purchased a significant share to sell to its wealthy clients, including a number of its executives and its own CEO, David Komansky. A similar strategy was employed by the Union Bank of Switzerland (The Washington Post, 9/27/98). LTCM's main strategy was to make convergence trades. These trades involved finding securities that were mispriced relative to one another, taking long positions in the cheap ones and short positions in the rich ones. There were four main types of trade: Convergence among U.S., Japan, and European sovereign bonds; Convergence among European sovereign bonds; Convergence between on-the-run and off-the-run U.S. government bonds; Long positions in emerging markets sovereigns, hedged back to dollars. Because these differences in values were tiny, the fund needed to take large and highly-leveraged positions in order to make a significant profit. At the beginning of 1998, the fund had equity of $5 billion and had borrowed over $125 billion a leverage factor of roughly thirty to one. LTCM's partners believed, on the basis of their complex computer models, that the long and short positions were highly correlated and so the net risk was small.

1994: Long-Term Capital Management is founded by John Meriwether and accepts investments from

80 investors who put up a minimum of $10 million each. The initial equity capitalisation of the firm is $1.3 billion. (The Washington Post, 27 September 1998) End of 1997: After two years of returns running close to 40%, the fund has some $7 billion under management and is achieving only a 27% return comparable with the return on US equities that year. Meriwether returns about $2.7 billion of the fund's capital back to investors because "investment opportunities were not large and attractive enough" (The Washington Post, 27 September 1998). Early 1998: The portfolio under LTCM's control amounts to well over $100 billion, while net asset value stands at some $4 billion; its swaps position is valued at some $1.25 trillion notional, equal to 5% of the entire global market. It had become a major supplier of index volatility to investment banks, was active in mortgage-backed securities and was dabbling in emerging markets such as Russia (Risk, October 1998) 17 August 1998: Russia devalues the rouble and declares a moratorium on 281 billion roubles ($13.5 billion) of its Treasury debt. The result is a massive "flight to quality", with investors flooding out of any remotely risky market and into the most secure instruments within the already "risk-free" government bond market. Ultimately, this results in a liquidity crisis of enormous proportions, dealing a severe blow to LTCM's portfolio. 1 September 1998: LTCM's equity has dropped to $2.3 billion. John Meriwether circulates a letter which discloses the massive loss and offers the chance to invest in the fund "on special terms". Existing investors are told that they will not be allowed to withdraw more than 12% of their investment, and not until December. 22 September 1998: LTCM's equity has dropped to $600 million. The portfolio has not shrunk significantly, and so its leverage is even higher. Banks begin to doubt the fund's ability to meet its margin calls but cannot move to liquidate for fear that it will precipitate a crisis that will cause huge losses among the fund's counterparties and potentially lead to a systemic crisis. 23 September 98: Goldman Sachs, AIG and Warren Buffett offer to buy out LTCM's partners for $250 million, to inject $4 billion into the ailing fund and run it as part of Goldman's proprietary trading operation. The offer is not accepted. That afternoon, the Federal Reserve Bank of New York, acting to prevent a potential systemic meltdown, organises a rescue package under which a consortium of leading investment and commercial banks, including LTCM's major creditors, inject $3.5-billion into the fund and take over its management, in exchange for 90% of LTCM's equity. Fourth quarter 1998: The damage from LTCM's near-demise was widespread. Many banks take a substantial write-off as a result of losses on their investments. UBS takes a third-quarter charge of $700 million, Dresdner Bank AG a $145 million charge, and Credit Suisse $55 million. Additionally, UBS chairman Mathis Cabiallavetta and three top executives resign in the wake of the bank's losses (The Wall Street Journal Europe, 5 October 1998). Merrill Lynch's global head of risk and credit management likewise leaves the firm. April 1999: President Clinton publishes a study of the LTCM crisis and its implications for systemic risk in financial markets, entitled the President's Working Group on Financial Markets (Governance and Risk Control-Regulatory guidelines-president's working group)

Analysis: The Proximate Cause: Russian Sovereign Default The proximate cause for LTCM's debacle was Russia's default on its government obligations (GKOs). LTCM believed it had somewhat hedged its GKO position by selling rubles. In theory, if Russia defaulted on its bonds, then the value of its currency would collapse and a profit could be

made in the foreign exchange market that would offset the loss on the bonds. Unfortunately, the banks guaranteeing the ruble hedge shut down when the Russian ruble collapsed, and the Russian government prevented further trading in its currency. (The Financial Post, 9/26/98). While this caused significant losses for LTCM, these losses were not even close to being large enough to bring the hedge fund down. Rather, the ultimate cause of its demise was the ensuing flight to liquidity described in the following section. The Ultimate Cause: Flight to Liquidity The ultimate cause of the LTCM debacle was the "flight to liquidity" across the global fixed income markets. As Russia's troubles became deeper and deeper, fixed-income portfolio managers began to shift their assets to more liquid assets. In particular, many investors shifted their investments into the U.S. Treasury market. In fact, so great was the panic that investors moved money not just into Treasurys, but into the most liquid part of the U.S. Treasury market -- the most recently issued, or "on-the-run" Treasuries. While the U.S. Treasury market is relatively liquid in normal market conditions, this global flight to liquidity hit the on-the-run Treasuries like a freight train. The spread between the yields on on-the-run Treasuries and off-the-run Treasuries widened dramatically: even though the off-the-run bonds were theoretically cheap relative to the on-the-run bonds, they got much cheaper still (on a relative basis). What LTCM had failed to account for is that a substantial portion of its balance sheet was exposed to a general change in the "price" of liquidity. If liquidity became more valuable (as it did following the crisis) its short positions would increase in price relative to its long positions. This was essentially a massive, unhedged exposure to a single risk factor. As an aside, this situation was made worse by the fact that the size of the new issuance of U.S. Treasury bonds has declined over the past several years. This has effectively reduced the liquidity of the Treasury market, making it more likely that a flight to liquidity could dislocate this market. Systemic Risk: The Domino Effect The preceding analysis explains why LTCM almost failed. However, it does not explain why this near-failure should threaten the stability of the global financial markets. The reason was that virtually all of the leveraged Treasury bond investors had similar positions: Salomon Brothers, Merrill Lynch, the III Fund (a fixed-income hedge fund that also failed as a result of the crisis) and likely others. There were two reasons for the lack of diversity of opinion in the market. The first is that virtually all of the sophisticated models being run by the leveraged players said the same thing: that off-the-run Treasuries were significantly cheap compared with the on-the-run Treasuries. The second is that many of the investment banks obtained order flow information through their dealings with LTCM. They therefore would have known many of the actual positions and would have taken up similar positions alongside their client. Indeed, one industry participant suggested that the Russian crisis was the crowning blow on a domino effect that had started months before. In early 1998, Sandy Weill, as co-head of Citigroup, decided to shut down the famous Salomon Brothers Treasury bond arbitrage desk. Salomon, one of the largest players in the on-the-run/off-the-run trade, had to begin liquidating its positions. As it did so, these trades became cheaper and cheaper, putting pressure on all of the other leveraged players.

Lessons to be learned: Market values matter LTCM was perhaps the biggest disaster of its kind, but it was not the first. It had been preceded by a number of other cases of highly-leveraged quantitative firms that went under in similar

circumstances. One of the earliest was Franklin Savings and Loan, a hedge fund dressed down as a savings & loan. Franklin's management had figured out that many of the riskier pieces of mortgage derivatives were undervalued because a) the market could not understand the risk on the risky pieces; and b) the market overvalued those pieces with well-behaved accounting results. Franklin decided it was willing to suffer volatile accounting results in exchange for good economics. More recently, the Granite funds, which specialised in mortgage-backed securities trading, suffered as the result of similar trading strategies. The funds took advantage of the fact that "toxic waste" (risky tranches) from the mortgage derivatives market were good economic value. However, when the Fed raised interest rates in February 1994, Wall Street firms rushed to liquidate mortgagebacked securities, often at huge discounts. Both of these firms claimed to have been hedged, but both went under when they were "margincalled". In Franklin's case, the caller was the Office of Thrift Supervision; in the Granite Fund's, the margin lenders. What is the common theme among Franklin, the Granite Funds and LTCM? All three depended on exploiting deviations in market value from fair value. And all three depended on "patient capital" -- shareholders and lenders who believed that what mattered was fair value and not market value. That is, these fund managers convinced their stakeholders that because the fair values were hedged, it didn't matter what happened to market values in the short run they would converge to fair value over time. That was the reason for the "Long Term" part of LTCM's name. The problem with this logic is that capital is only as patient as its least patient provider. The fact is that lenders generally lose their patience precisely when the funds need them to keep it in times of market crisis. As all three cases demonstrate, the lenders are the first to get nervous when an external shock hits. At that point, they begin to ask the fund manager for market valuations, not models-based fair valuations. This starts the fund along the downward spiral: illiquid securities are marked-to-market; margin calls are made; the illiquid securities must be sold; more margin calls are made, and so on. In general, shareholders may provide patient capital; but debt-holders do not. The lesson learned from these case studies spoils some of the supposed "free lunch" features of taking liquidity risk. These plays can indeed generate excellent risk-adjusted returns, but only if held for a long time. Unfortunately the only real source of capital that is patient enough to take fluctuations in market values, especially through crises, is equity capital. In other words, you can take liquidity bets, but you cannot leverage them much. Liquidity risk is itself a factor As pointed out in the analysis section of this article, LTCM fell victim to a flig ht to liquidity. This phenomenon is common enough in capital markets crises that it should be built into risk models, either by introducing a new risk factor liquidity or by including a flight to liquidity in the stress testing (see the following section for more detail on this). This could be accomplished crudely by classifying securities as either liquid or illiquid. Liquid securities are assigned a positive exposure to the liquidity factor; illiquid securities are assigned a negative exposure to the liquidity factor. The size of the factor movement (measured in terms of the movement of the spread between liquid and illiquid securities) can be estimated either statistically or heuristically (perhaps using the LTCM crisis as a "worst case" scenario). Using this approach, LTCM might have classified most of its long positions as illiquid and most of its short positions as liquid, thus having a notional exposure to the liquidity factor equal to twice its total balance sheet. A more refined model would account for a spectrum of possible liquidity across securities; at a minimum, however, the general concept of exposure to a liquidity risk factor should be incorporated in to any leveraged portfolio. Models must be stress-tested and combined with judgement

Another key lesson to be learnt from the LTCM debacle is that even (or especially) the most sophisticated financial models are subject to model risk and parameter risk, and should therefore be stress-tested and tempered with judgement. While we are clearly privileged in exercising 20/20 hindsight, we can nonetheless think through the way in which judgement and stress-testing could have been used to mitigate, if not avoid, this disaster. According to the complex mathematical models used by LTCM, the positions were low risk. Judgement tells us that the key assumption that the models depended on was the high correlation between the long and short positions. Certainly, recent history suggested that correlations between corporate bonds of different credit quality would move together (a correlation of between 90-95% over a 2-year horizon). During LTCM's crisis, however, this correlation dropped to 80%. Stresstesting against this lower correlation might have led LTCM to assume less leverage in taking this bet. However, if LTCM had thought to stress test this correlation, given that it was such an important assumption, it would not even have had to make up a stress scenario. This correlation had dropped to 75% as recently as 1992 (Jorion, 1999). Simply including this stress scenario in the risk management of the fund might have led LTCM to assume less leverage in taking this bet. Financial institutions must aggregate exposures to common risk factors One of the other lessons to be learned by other financial institutions is that it is important to aggregate risk exposures across businesses. Many of the large dealer banks exposed to a Russian crisis across many different businesses only became aware of the commonality of these exposures after the LTCM crisis. For example, these banks owned Russian GKOs on their arbitrage desks, made commercial loans to Russian corporates in their lending businesses, and had indirect exposure to a Russian crisis through their prime brokerage lending to LTCM. A systematic risk management process should have discovered these common linkages ex ante and reported or reduced the risk concentration.

Getting a Handle on Uncertainty

Liquidity Risk Management for a Bank


A framework for estimating liquidity risk capital for a bank
From Jawwad Farid Capital estimation for Liquidity Risk Management is a difficult exercise. It comes up as part of the internal liquidity risk management process as well as the internal capital adequacy assessment process (ICAAP). This post and the liquidity risk management series that can be found at the Learning Corporate Finance blog suggests a framework for ongoing discussion based on the work done by our team with a number of regional banking customers. By definition banks take a small Return on asset (1% 1.5%) and use leverage and turnover to scale it to a 15% 18% Return on Equity. When market conditions change and a bank becomes the subject of a name crisis and a subsequent liquidity run, the same process becomes the basis for a death chant for the bank. We try to de-lever the bank by selling assets and paying down liabilities and the process quickly turns into a fire sale driven by the speed at which word gets out about the crisis.

Figure 1 Increasing Cash Reserves Reducing leverage by distressed asset sales to generate cash is one of the primary defense mechanisms used by the operating teams responsible for shoring up cash reserves. Unfortunately every slice of value lost to the distressed sale process is a slice out of the equity pool or capital base of the bank. An alternate mechanism that can protect capital is using the interbank Repurchase (Repo) contract to use liquid or acceptable assets as collateral but that too is dependent on the availability of un-encumbered liquid securities on the balance sheet as well as availability of counterparty limits. Both can quickly disappear in times of crisis. The last and final option is the central bank discount window the use of which may provide temporary relief but serves as a double edge sword by further feeding the name and reputational crisis. While a literature review on the topic also suggest cash conservation approaches by a re-alignment of businesses and a restructuring of resources, these last two solutions assume that the bank in question would actually survive the crisis to see the end of re-alignment and re-structuring exercise.

Liquidity Reserves: Real or a Mirage


A questionable assumption that often comes up when we review Liquidity Contingency Plans is the availability or usage of Statutory Liquidity and Cash Reserves held for our account with the Central Bank. You can only touch those assets when your franchise and license is gone and the bank has been shut down. This means that if you want to survive the crisis with your banking license intact there is a very good chance that the 6% core liquidity you had factored into your liquidation analysis would NOT be available to you as a going concern in times of a crisis. That liquidity layer has been reserved by the central bank as the last defense for depositor protection and no central bank is likely to grant abuse of that layer.

Figure 2 Liquidity Risk and Liquidity Run Crisis As the Bear Stearns case study below illustrate the typical Liquidity crisis begins with a negative event that can take many shapes and forms. The resulting coverage and publicity leads to pressure on not just the share price but also on the asset portfolio carried on the banks balance sheet as market players take defensive cover by selling their own inventory or aggressive bets by short selling the securities in question. Somewhere in this entire process rating agencies finally wake up and downgrade the issuer across the board leading to a reduction or cancellation of counterparty lines. Even when lines are not cancelled given the write down in value witnessed in the market, calls for margin and collateral start coming in and further feed liquidity pressures. What triggers a Name Crisis that leads to the vicious cycle that can destroy the inherent value in a 90 year old franchise in less than 3 months. Typically a name crisis is triggered by a change in market conditions that impact a fundamental business driver for the bank. The change in market conditions triggers either a large operational loss or a series of operation losses, at times related to a correction in asset prices, at other resulting in a permanent reduction in margins and spreads. Depending on when this is declared and becomes public knowledge and what the bank does to restore confidence drives what happens next. One approach used by management teams is to defer the news as much as possible by creative accounting or accounting hand waving which simply changes the nature of the crisis from an asset price or margin related crisis to a much more serious regulatory or accounting scandal with similar end results.

Figure 3 What triggers a name crisis? The problem however is that market players have a very well established defensive response to a name crisis after decades of bank failures. Which implies that once you hit a crisis the speed with which you generate cash, lock in a deal with a buyer and get rid of questionable

assets determined how much value you will lose to the market driven liquidation process. The only failsafe here is the ability of the local regulator and lender of last resort to keep the lifeline of counterparty and interbank credit lines open. As was observed at the peak of the crisis in North America, UK and a number of Middle Eastern market this ability to keep market opens determines how low prices will go, the magnitude of the fire sale and the number of banks that actually go under.

Figure 4 Market response to a Name Crisis and the Liquidity Run cycle. The above context provides a clear roadmap for building a framework for liquidity risk management. The ending position or the end game is a liquidity driven asset sale. A successful framework would simply jump the gun and get to the asset sale before the market does. The only reason why you would not jump the gun is if you have cash, a secured contractually bound commitment for cash, a white knight or any other acceptable buyer for your franchise and an agreement on the sale price and shareholders approval for that sale in place. If you are missing any of the above, your only defense is to get to the asset sale before the market does.

The problem with the above assertion is the responsiveness of the Board of directors and the Senior executive team to the seriousness of the name crisis. The most common response by both is a combination of the following a) The crisis is temporary and will pass. If there is a need we will sell later. b) We cant accept these fire sale prices. c) There must be another option. Please investigate and report back. This happens especially when the liquidity policy process was run as a compliance checklist and did not run its full course at the board and executive management level. If a full blown liquidity simulation was run for the board and the senior management team and if they had seen for themselves the consequences of speed as well as delay such reaction dont happen. The board and the senior team must understand that illiquid assets are equivalent of high explosives and delay in asset sale is analogous to a short fuse. When you combine the two with a name crisis you will blow the bank irrespective of its history or the power of its franchise. When the likes of Bear, Lehman, Merrill, AIG and Morgan failed, your bank and your board is not going to see through the crisis to a different and pleasant fate.

Estimating Capital for Liquidity Risk: The framework


If we agree on the above then from a liquidity risk capital estimation point of view you have to answer the following questions a) What would a liquidity driven disruption of normal business, cost this bank in terms of opportunity and real costs? The primary focus of this question is in the loss of future business and loss of spread on that business.

b) What is the expected contraction in balance sheet size and spread income that we will suffer in case of a liquidity crisis within our existing book of business? (Not future but current) c) What is the expected loss that will be realized due to a fire sale of liquid and illiquid assets to shore up cash reserves? d) What is the additional interest expense that we will book in case of tightening of credit markets? The actual estimated liquidity risk capital would be a weighted combination of the above 4 elements. How do we actually go about estimating this capital estimate for liquidity risk? Start with a valuation model and do a full valuation for the business on an as is going concern basis. If you like you can calibrate the model with the current market price of your institution. Lets call this Base Case A. Now reduce the growth rate to zero. This revised price is Base Case B. Now turn the growth negative by the estimated reduction in your book size. This is Base Case C. The difference between Base Case B and Base Case A is your capital estimate for (a) above. The difference between Base Case C and Base Case B give you the capital estimate for (b). The third piece (liquidation cost) is more complex and would require and asset by asset estimate of liquidity haircuts (value at risk driven) but is a pure mechanical exercise. The last and final piece is simpler and is your current liquidity gap (or your expected liquidity gap) multiplied by the worst case (a value at risk estimate) incremental interest rate cost you are likely to experience in a liquidity crisis.

Liquidity Risk Management: Conclusion


I thought it would be useful to close with the example of how long did it actually take for a liquidity driven crisis to sink Bear Stearns. The sidebar that follows presents a summarized timeline of the 14 weeks it took for Bear to go under.

Bear Stearns Liquidity Run Case Study Timelines


20 December 2007: BS records 4th quarter loss, writes down mortgage assets of $1.9 billion. Sued by Barclays for misleading hedge fund performance 28 December 2007: Employees sell BS stock worth $ 20 million Early January 2008: CEO James Cayne resigns. Moodys downgrade of MBS tranches issued by BS Mid-January 2008: Over 20% fall in BS share price 7 March 2008: Shares of Carlyle Capital Corporation (CCC), to which BS has significant exposure, suspended because of margin calls and defaults notices by lenders. Triggers concerns regarding liquidity

10 March 2008: BS Press Release to reassure investors that liquidity concerns are false. Rumors of loss of confidence and loss of credit facilities. 11 March 2008: CFO says rumors false. Goldman Sachs says it will not stand in for it clients if they wished to undertake derivative deals with BS 12 March 2008: CEO says no liquidity crisis on CNBC and that quarter will show profit. Banks withdraw credit lines and clients stop using BS brokerage 13 March 2008: CCC hedge fund collapses. BS share price falls 17%. CEO announces all is well. Liquidity falls from $17 billion to $2 billion. 13 March 2008: CEO approaches JP Morgan for rescue package and clients to express confidence in BS publicly. Latter declined. 14 March 2008: BS says JP Morgan with Fed Reserve has agreed to provide funding. Share price falls 40%. S&P and Moodys cut BS ratings 16 March 2008: JP Morgan announces that they have acquired BS for $2 per share This post appeared previously on the Learning Corporate Finance blog and can be seen here.

Liquidity Risk Management Case Study: The Liquidity run cycle illustrated: Bear Stearns June 2007 to 16th March 2008
By Administrator on February 5th, 2011

Liquidity Risk management: Bear Stearns Case Study: The Liquidity Run cycle
When property values began to plummet in 2006 -2007, subprime mortgage payers defaulted on their payments which initiated a chain reaction whereby there was a significant drop in the cash inflows from these mortgages which would have been used to pay off the obligations on the derivate instruments. With the decline in property value and the subsequent impact on mortgage payments the values of the mortgage backed derivate instruments also fell as investors tried to liquidate their positions in these instruments in a relatively illiquid market.

Bear Stearns Case Study: The beginning of the Name crisis


On 14th June 2007 Bears Stearns reported a decline of 10% in profits for the second quarter over the previous quarters profits to $486 million. On 18 th June 2007 Merrill Lynch seized the $850 million of the collateral comprising of thinly traded CDOs, of one of hedge funds that were heavily invested in subprime mortgages due to increased margin calls and failure of payment of debt obligations by the hedge fund because of the depressed value and illiquid market of its assets. When Merrill Lynch went to liquidate these derivates, they were only able to do so fractionally (only $100 million worth could be auctioned) and that too at marked down values because of the lack of market liquidity for these instruments. This led to Bear Stearns pledging $3.2 billion in secured loans to bail out one of its subprime hedge funds, Bear Stearns High-Grade Structured Credit Fund on 22 June 2007 together with negotiating loans with other banks against its collateral to bail out another hedge fund, Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund. This was done in order to counter what the failure of these hedge funds would do to its reputation as well as how the asset values could be impacted if the collateral continued to be sold in the illiquid and depressed market . On 17th July 2007 as a result of the continually declining value of the subprime mortgages and the resulting fall is asset values of the deriva tive securities, Bear Stearns revealed to its clients that the hedge funds had lost all or almost all of their value. Investors in the two hedge funds sued Bear Stearns for the collapse of the funds and sought arbitration claims saying that the bank had mi sled them about its exposure to these funds. In response the funds filed for bankruptcy protection on 1 st August 2007 and the company froze the assets of a third fund. The amount lost was around $1.6 billion. The co-president and the person responsible for the management of these funds, Warren Spector, who was much touted to succeed Bear Stearns chief executive James Cayne resigned on 5 th August 2007 following the collapse of the funds. On August 6th, the bank reassured clients by letter that the company wa s financially sound with the necessary experience and expertise to deal with challenging

markets. On 17 th August 2007 Bear Stearns cut 240 jobs from the loan origination units of the bank. On 20 th September 2007, the bank reported a drop of 61% in profits for the quarter to $171 million. In early October 2007 Bear Stearns CEO and president informed the public that most of its businesses were beginning to recover. It cut an additional 300 jobs. On 22 October 2007, it received an injection into its funding when it entered a share-swap deal with CITIC, Chinas largest state -owned securities firm. Under the deal CITIC would pay Bear Stearns $1 billion for a 6% share in it with an option to buy a further 3.9% of the investment bank and in return Bear Stearns would eventually pay a similar amount for a 2% share in CITIC. On November 14 2007 its CFO Molinaro reported that it would write down its assets and book a 4 th quarter loss. This resulted in a ratings downgraded by S&P 500 from A+ to A stating that the outlook was negative. End November 2007 it released news that it planned to further reduce its global workforce by 4% or 650 jobs. Early December 2007 Joe Lewis an influential shareholder increased his share in Bear Stearns on grounds that he believed the banks s hares to be undervalued and that the bank was on its way to recovery. The bank registered its first loss in its 85-year history in the 4 th quarter of 2007 amounting to $854 million due to a write down of $1.9 billion of the value of its holdings of mortgage assets. Barclays bank sued Bear Stearns for allegedly misleading them about the performance of the two collapsed hedge funds which were pledged as collateral against a $400 million loan granted to Bears asset management division. Top employees of the company said theyd skip their bonuses but they including the CEO Cayne sold their companys stock together worth over $20 million in December 2007. James Cayne resigned as CEO in early January 2008 though remained as the banks non-executive chairman with a remaining 5% share in the bank. Moodys Investors Service downgraded the ratings of 46 tranches issued by Bear Stearns in 2006 (including 24 to junk status) and an additional 11 tranches of Alt-A deals issued in 2007 were also place under review for possi ble down based on higher than expected rates of default and foreclosure.

Due to the news of the quarters losses, sales of stock by the top employees and downgrades of its derivative securities including a more general concern that the US economy would slip into a recession, Bears Stearns share price fell drastically by more than 20%. As a result of this fall it was reported in mid -February 2008 that CITIC the Chinese state owned lender had begun to renegotiate their share -swap agreement with the bank. On March 7 2008, the Carlyle Capital Corporation, a hedge fund had suffered because of the subprime crisis had received substantial margin calls and default notices from its lenders. Due to this it had its shares suspended in Amsterdam. As the Carlyle Group was founded by Bear Stearns which also had a 15% shareholding in the Carlyle Capital Corporation many investors and clients viewed Bear Stearns as been heavily exposed to it. This fueled concerns regarding whether or not the investment bank had sufficient cash/ funds to do business. The cost of insuring $10 million worth of Bear Stearns credit default swap debt went from $ 350,000 to over $ 1 million. Borrowing costs for Bear Stearns began to rise sharply. In response to this Bear issued a press release on 1 0th March 2008 stating that there were no grounds for any rumors regarding their lack of liquidity saying that it has $17 billion in cash. However, the fact that a public announcement has been made was read as a signal by many Wall Street experts, that the bank was in trouble. There were also reports that a major bank had refused to lend to Bear via a repo transaction a short term loan of $2 billion and therefore rumors persisted that the bank was losing confidence among its creditors. On 11 th March Bear continued to reassure it customers and investors that nothing was wrong with its liquidity position with CFO Molinaro announcing on CNBC that the rumors were false. However on the same day Goldman Sachs credit derivative group told its clients via email tha t it would no longer step in on their behalf to executive derivative deals with Bear Stearns. Other banks too refused to provide further credit protection against Bear Stearns debt. On 12 th March 2008 the CEO Alan Schwartz made gave a televised assurance t o investors that there was no liquidity crisis and that the first quarter of 2008 would likely turn a profit for the bank. However when the news regarding the Gold Sachs email leaked into the market many more hedge funds and clients began withdrawing their funds from the bank. Banks were backing out of providing credit

and Bear Stearns credit lines were dramatically reduced. Hedge funds, mutual funds and capital management companies stopped using Bear Stearns brokerage service for executing their trades. On 13 th March 2008 the Carlyle Capital Corporation hedge fund collapsed which resulted in a fall in the Bear Stearns share price of 17%. The CEO publicly continued to maintain that all was well and that the collapse of the hedge fund and subsequent fall in share value had not weakened the banks balance sheet. However liquidity had now dropped to $2 billion. Schwartz approached JP Morgan to negotiate a rescue package. In the meantime the bank contacted a major client to encourage them to publicly express their confidence in Bear. The client declined. On 14 th March 2008 Bear Stearns confirmed the news that they had secured short term funding amounting to $30 billion from JP Morgan, the clearing agent for its collateral, in order to stabilize its position, str engthen its liquidity and meet the demands of its lenders. The collateral pledged would be backed by the Federal Reserve Bank of New York against the risk of its decline. However this funding was not sufficient to quell fears by investors regarding Bear St earns financial stability and share prices fell by more than 40% on the news. S&P and Moodys slashed ratings on the bank to just above junk status with a warning that further downgrades were possible. On 16th March 2008 JP Morgan announced that it had acq uired Bear Stearns for $2 per share. By March 24 th 2008 the offer was raised to $10 per share in order to appease Bear Stearns shareholders. This was eventually approved by them.

Liquidity Risk Management Case Study: American International Group (AIG)


By Agnes on February 21st, 2011

AIG Financial Productions Corporation (AIG FP) a subsidiary of AIG issued and traded credit default swaps. These non-traditional insurance instruments insured the counterparty in the event of default on collateralized debt obligation payments. The company believed that the risk was very small because they primarily insured AAA- rate tranches which they presumed would be close to risk-free.

However what they failed to factor was the significant risk factor that as per contractual agreement they were required to post collateral with the counterparties in the event that values on the underlying CDOs declined; also that in the eventuality of a down-grade in their credit ratings they would be required to post additional collateral with their counterparties. During the years prior to the financial crisis and even during the crisis AIG was confident that the risks that they were exposed to, in terms of declining values of CDOs and down-grades, were negligible because they believed that the market would eventually recover and that they were too big an entity to fail. In August 2007, subsequent to growing delinquencies in the subprime market and falling values of mortgage-backed instruments, Goldman Sachs demanded that AIG post collateral to cover its exposure to the fall in market value of its CDO portfolio. In October 2007 Goldman again insisted on yet more collateral from AIG. In total AIG ended up posting around $2 billion in collateral with them upto end-October 2007. In November 2007, AIG reported $352 million in unrealized losses on its CDS portfolio. However AIG also reported that they would most likely not realize these losses as they believed that the market would recover. What they also reported was that there were disagreements between counterparties and AIG regarding the amount needed as collateral. This suggested that there were differences in the valuations given to the underlying CDO portfolio by the insurance company and their counterparties. Further, AIGs external auditor PricewaterhouseCoopers privatel warned the y CEO that there were material weaknesses in the way AIGs managed the risk of its CDS portfolio in particular with the risk models that they used to value the portfolio and assess its risk. In December 2007 AIG reported a further $1.15 billion in unrealized losses on its CDS portfolio. Despite this substantial increase in losses AIG continued to tell investors that based on their risk models they believed that there was a very negligible possibility that any of these losses would actually be realized. On 11th February 2008 the company disclosed the concerns of their auditor regarding the material weakness of their valuation and risk models used for the CDS portfolio. In light of these concerns the company revised unrealized losses November-estimates upwards to $5.96 billion and on 28th February 2008, they disclosed revised year-end unrealized losses of $11.5 billion. They also reported that they had been required to post a total of $5.3 billion as collateral to date. AIG again tried to assuage investors fears by emphasizing that these losses were not expected to be realized as the unrealized value would be reduced as the market recovered. They also informed that that the chief of AIGFP, Joe Cassano, the unit responsible for this swap portfolio had resigned.

On 8th March 2008, AIG reported additional unrealized losses for the first quarter on $9.1 billion also revealing that the total collateral that it had been required to post had risen to $9.7 billion. On 20th March 2009 in order to strengthen its capital position it was able to raise $20 billion in private capital. In June- August 2008 it reported $5.6 billion unrealized losses for the second quarter of 2008 and that total collateral posted now stood at $16.5 billion. The CEO of AIG, Martin Sullivan resigned and was replaced by Robert Willumstad. On 9th September 2008 AIGs share price fell sharply by 19%, the biggest drop since it became a public company in 1969, in response to investors fears regarding the potential collapse of Lehman Brothers and its systemic impact on AIGs ability to meet its own commitments as well as the fact that AIG was finding it difficult to raise capital. Following the bankruptcy filing of Lehman Brothers after the governments refusal to provide it with a bailout and the unexpected systemic impacts that the announcement had had on the financial markets, the Federal Reserve began to have concerns regarding the potential collapse of AIG if it was allowed to fail. In view of this on 14 th September 2008, Federal Reserve asked private entities to provide AIG with short term bridge loans to help AIG meet its liquidity demands. In addition the FDIC relaxed rules to allow AIG to around $20 billion from its subsidiaries. Despite these efforts from the regulators, on 15th September 2008 credit rating companies downgraded AIGs credit rating below AA-levels because of its increasing inability to meet collateral demands as well as because of its growing residential mortgage-backed losses. Following the down grading counterparties demanded $14.5 billion to be posted as additional collateral. In addition to this investors discovered that AIGs subprime and Alt-A mortgages were valued significantly higher as compared to similar assets on Lehmans balance sheet. In light of these developments AIGs share price declined sharply by 61%. On 16th September 2008, with AIGs share price still headed downwards, the Federal Reserve bank announced a bailout package for the insurer. It provided an $85 billion credit -liquidity facility, backed by collateral consisting of assets of AIG and its subsidiaries, payable at an interest rate 8.5% over the 3-month LIBOR, in exchange for warrants for a 79.9% equity share in the company. These terms were accepted by AIGs board. This turned out to be the first of a number of bailouts provided by the government to AIG to keep it from failing.

On 17th September 2008, the CEO, Willumstad was forced to resign and was replaced by Edward Liddy. In early October 2008, the Fed provided an additional $37.8 billion to AIG, the second bailout, as it struggled to meet demands of cash from its clients withdrawing from its securities lending program. In the case of the latter, AIG had lent clients securities in return for cash which it had in turn invested in other securities. Due to the loss in value of these other securities AIG could not honor the demands of its clients. With the new bailout facility the Fed agreed to borrow these other securities in return for cash so that AIG could in turn close the outstanding deals with its clients. The government also imposed bonus and pay restrictions for its employees and executives on AIG. AIG continued to use the loan to pay off its obligations on credit default swaps purchased to hedge against defaults of Lehman and other bankrupted entities. It also announced plans to sell of its life insurance operations in various countries. However, AIGs credit default spreads continued to widen during this period, an indicator that the company was headed for default. In light of this the government announced a third bailout on 10th November 2008. As part of this bailout, the terms and conditions of AIGs original bailout loan were modified including lowering the interest rate and extending the term of the loan. In addition the government agreed to purchase $40 billion of senior preferred stock as well as it created two entities that would purchase over $50 billion worth of residential mortgage-backed securities, that were either owned by AIG and CDOs owned by counterparties and guaranteed by AIGs CDS. By February 2009, AIG had raised only $2.4 billion in divestures and asset sales. However news reported indicated that CEO was not going ahead with plans to fund bailout loan repayments through the sales of AIG assets because of the difficulty in finding strong potential buyers and because of the declining valuation of its insurance assets. Following reported losses of $61.7 billion,
nd the government enhanced the rescue package to AIG on 2 March 2009 by providing more favorable

terms such as lower, non-cumulative, dividend payments on the preferred stock already purchased by the government, purchasing an additional $30 million worth of preferred stock and restructuring of the company including putting two life insurance subsidiaries into separate trusts of which the Federal Reserve would purchase up to $26 billion in preferred stock. In early August 2009, CEO Liddy was replaced by former MetLife CEO Robert Benmosche as president and CEO of AIG.

Since receiving its first bailout AIG has continued to sell its assets, including its asset management businesses and major insurance subsidiaries, using the proceeds to pay -off its loan to the government. In September 2010 it announced a plan to repay the government loan off early by allowing the US Treasury to swap the preferred stock that it holds for common stock, a 92% stake in AIG, which could then be sold in the market. In addition it would pay off the Federal Reserve loan through earnings and asset sales. AIG is expected to sell $10-$30 million shares to the public in a re-IPO of the company, with the US Treasury being the primary seller to the deal, in April- May 2011.

Liquidity Risk Management Case Study: Lehman Brothers


By Agnes on February 21st, 2011

Between 2003 and 2004 Lehman Brothers acquired five mortgage lenders including the subprime originator BNC Mortgage LLC and Alt- A mortgage originator Aurora Loan Services. During the house price bubble these acquisitions contributed to Lehman achieving record revenues and becoming the fastest growing investment bank or asset management company by revenue. In 2007 it surpassed Bear Stearns in becoming the largest underwriter for mortgage-backed securities. It retained a significant portion of these securities on its books amounting to $85 billion or around four times its equity. Due to this growth its share price reached an all time high of $86 in February 2007. On March 13 2007 the stock market suffered its largest one-day drop in five years amidst fears that the growing number of defaults in the subprime mortgage market, to which Lehman was significantly exposed, would affect its profitability. However on March 14 2007, Lehman reported a record in revenue generation and profits for its first fiscal quarter claiming that the growing defaults would not significantly impact its earnings as losses were being effectively controlled. However as delinquencies in the subprime market continued which also led to the collapse of two
nd Bears Stearns hedge funds and a sharp decline in Lehmans share value, the bank announced on 22

August 2007 that it would be closing down its subprime mortgage originator BNC Mortgage which eliminated 1200 jobs. It also closed down its Alt-A originator offices in a number of states. However as the subprime crisis continued it continued to actively generate mortgages through its other mortgage lending acquisitions as well as continued to underwrite and issue mortgage-backed securities.

On 13th December 2007 Lehman reported record net income for the year of $4.2 billion and revenue of $19.3 billion due to a temporary recovery in the fixed income market and what appeared to b e promising gains in global equity markets. However it remained highly leveraged with a leverage ratio (Assets/ Equity) of 31 to 1 making it very vulnerable to a deteriorating market situation. Lehman failed to avail the opportunity to cut down its large positions in risky assets at this time on the premise that financial markets would eventually recover. On 17th January 2008 as defaults continued to rise and house prices continued to decline Lehman announced that it would stop originating mortgages through its wholesale channels. 17th March 2008 saw Lehmans share price decline sharply by more than 48% following the collapse
th of Bear Stearns and the Federal-government backed takeover by JP Morgan Chase & Co. on 16

March 2008 which raised concerns in the market whether other investment banks, in particular Lehman, would meet the same fate. There were reports that on that day South Asian Bank DBS Group Holding Limited instructed its traders not to work with Lehman. These instructions were later withdrawn. Better than expected reported profits for the first fiscal quarter on 18th March 2008 caused Lehman share prices to rise regaining the value lost the previous day. On 1st April 2008 it also announced that it had raised $4 billion in preferred stock which could be converted to common stock at a 32% premium to its current value. These events help to restore investors confidence to an extent, in Lehman brothers. On 15th April 2008 Lehmans CEO Richard Fuld told investors that he believed that the worst of the crisis had passed but that the financial environment would remaining challenging for some time to come. In May 2008, Lehmans share price continued to fall on reports that its hedge fund managers questioned it first quarter results on the belief that mortgage assets had not been valued correctly. On 16th May 2008 it trimmed an additional 5% of its work force, i.e. 1,400 jobs cuts. On 9th June 2008 Lehman announced its first quarterly loss of $3 billion since becoming a public company after its spin-off from American Express, as a result of losing around 73% of its value due to the worsening credit crisis. To counter this loss, Lehman announced that it had sold $6billion in stock to strengthen its capital position, increased its liquidity to $45 billion, reduced its assets by $147 billion decreasing its exposure to residential and commercial mortgages by 20%. All of this had resulted in a lower leverage ratio of 25 to 1. In addition, on 12th June 2008 its CFO, Erin Callan was

removed and the president and COO , Joseph Gregory stepped down and was replaced by Herbert McDade. On 19 August 2008 Lehmans share price fell by around 13% due to reports that 3-quarter results would reveal significant write down in its assets and that it was looking for buyers for its investment management business. On 22nd August 2008 its stock price recovered some of its value on news that was the stateth controlled Korean Development Bank was considering buying it. Further on 29 August reports also

indicated that Lehman planned to cut an additional 6% of its work force amounting to 1500 jobs prior to the deadline of its third-quarter results. On 2nd September 2008 news reports suggested that KDB would purchase a 25% stake in Lehman. On 8th September 2008 the share price for Lehman fell sharply on reports that the talks with KDB had been put talks on hold due to rapidly declining values of global equity markets, lack of backing from KDBs regulators and difficulty in finding partners for the deal. Also Lehman itself had difficulty attracting new investors and therefore struggled to raise new capital. When news reports on 9th September indicated that the talks had ended the 45% fall in Lehmans stock price pushed the S&P 500 and Dow Jones down. This was exacerbated when the US government announced that it would not bail out Lehman as it had done Bear Stearns if the situation became critical. Credit Default Swaps, default insurance for Lehmans debt increased significantly, a reverse indicator of how the markets perceived Lehmans financially strength. This resulted in a run on the bank with hedge fund clients pulling out, lines of credit being withdrawn, great margin/ collateral calls and trades being cancelled. On 10th September 2008 in its third quarter results it reported a loss of $3.2 billion as a result of asset write-downs amounting to $5.6 billion. In order to build up investor confidence it also announced that it planned to spin off its commercial real estate assets and a major stake of its asset management unit, Neuberger Berman. However as a result of the announcement its stock price declined a further 7%. Moodys also announced that it would review Lehmans ratin and that gs it would have to down grade the entity if it could not find a strong buyer. On 11-12th September 2008 Lehmans stock declined a further 42% as it struggled to find a buyer. Through the efforts for the US Treasury and Federal Reserve who urged t Wall Street CEOs to he come up with a solution for Lehman, Bank of American and Barclays comes forward as potential buyers. By the weeks end Lehman has only $1 billion in cash. In the event that a deal did not

materialize therefore there was possibility that it could lead to an emergency liquidation of its assets. 13th-14th September 2008 Wall Street leaders continued to meet with regulators over the week end to come up with a possible solution. The two potential buyers wanted the government to provide a back stop guarantee as it had done for JP Morgan in the case of Bear Stearns. However the government insisted that it would not provided assistance this time. Barclays bank ended its bid when the US regulators assistance was not forthcoming and when its deal was vetoed by the Bank of England and the UKs Financial Services Authority. Bank of America also withdrew its bid. The latter diverted its focus to acquisition negotiations with another investment bank, Merrill Lynch, which it subsequently acquired in an emergency deal the following day. On 15th September 2008, due to the failure of negotiations and no change in the US governments position regarding the possibility of a bail out, Lehman filed for bankruptcy protection. With $639 billion in assets it was the largest bankruptcy filing in US history causing the Dow Jones to suffer its largest drop in a single day since 11th September 2001. The bankruptcy led to a loss of over $46 billion of Lehmans market value. On 22nd-23rd September 2008 the bankruptcy court approved the sale of Lehmans brokerage holding to Barclays and its Asian pacific franchise to Nomura Holdings Inc. The latter also announced plans to acquired Lehman holdings in Europe and Middle East which it completed in October 2008.