1. CASE: BEAR STEARNS
Following is the timeline of the events that led Bear Stearns to suffer huge losses.
YEAR 2007
JUNE 22
Bear Stearns commits $3.2bn in secured loans to bail out one of its hedge funds. It says its troubles are 'relatively contained'.
JULY 17
Bear Stearns reveals that one of its hedge funds has lost all of its value. Another worth 9 per cent of its value at the end of April.
AUGUST 5
Co-president Warren Spector resigns after the collapse of the two exposed hedge funds. He was seen as the favourite to succeed chief executive Jimmy Cayne.
AUGUST 17
Bear Stearns slashes 240 jobs in two mortgage origination units. In early October, the bank culls over 300 more jobs.
OCTOBER 22
Bears Stearns secures a share-swap deal with Citic, China's largest securities firm. Citic pays $1bn for about 6 per cent stake in Bear Stearns. The US bank agrees to eventually pay the same for about 2 per cent of Citic.
NOVEMBER 1
A US newspaper suggests that Cayne was out of touch during the collapse of the two hedge funds. He dismisses the media concerns as "noise".
DECEMBER 7
Joe Lewis, Bahamas-based billionaire, up his stake to 8 per cent, showing that he believes the Bear Stearns shares are undervalued.
DECEMBER 20
The bank reports its first-ever quarterly loss. The loss is nearly four times analysts' forecasts, and includes a $1.9bn writedown on its holdings of mortgage assets.
2008
JANUARY 7
CEO Cayne retires under pressure, but stays on as non-executive chairman. Alan Schwartz becomes president and chief executive.
FEBRUARY 14
In reaction to the fall in the bank's share price since the share-swap deal, it emerges that Citic has been renegotiating the agreement.
FEBRUARY 28
Rebel investors in Bear Stearns seize two of the bank's failed hedge funds in an attempt to regain some of the $1.6bn lost in the previous summer's collapse.
MARCH 7
Carlyle Capital Corporation sees its shares suspended in Amsterdam.
The $22bn hedge fund suffered exposure to mortgage backed securities, and had received substantial additional margin calls and default notices from its lenders.
Bear Stearns is seen as heavily exposed to Carlyle Group, founder and 15 per cent owner of CCC.
MARCH 13
CCC collapses. Bear Stearns shares fall 17 per cent as investors grow anxious about its exposure to CCC. Schwartz comments: "Our balance sheet is not weakened at all."
MARCH 14
JP Morgan and the New York Federal Reserve rush to the rescue of Bear Stearns. Shares crash almost 50 per cent.
MARCH 16
JP Morgan agrees to buy Bear Stearns in a deal that values the stricken bank's shares at $2 each, with JP Morgan exchanging 0.05473 of each of its shares for one Bear share.
MARCH 22
A powerful group of shareholders including British billionaire Joe Lewis plot a legal challenge against the $2 a share, cut-price offer.
MARCH 23
It emerges that JP Morgan is in talks with the US Federal Reserve and Treasury Department about a possible increased offer for Bear Stearns.
MARCH 24
JP Morgan raises its offer for Bear Stearns to $10 a share in a bid to quell shareholder dissent about the discounted nature of the takeover.
MARCH 25
March 25 Jimmy Cayne, Bear Stearns’ chairman and former chief executive, sells his 5pc stake for $61m.
Bear Stearns losses in derivatives first became evident when two Bear Stearns hedge funds collapsed in July 2007
Now we'll first examine how unrestricted use of derivatives caused the implosion of two prominent Bear Stearns hedge funds, the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund.
Bear Stearns had some compensation structures which encouraged greedy, risk-taking behaviour that normally involves leverage to generate sufficient returns to justify the enormous management and incentive fees. Both of Bear Stearns' troubled funds fell well within this generalization.
In fact, as it was this derivatives leverage itself that primarily precipitated their failure.
Investment Structure
The strategy employed by the Bear Stearns funds was actually quite simple and would be best classified as being a leveraged credit investment. In fact, it is formulaic in nature and is a common strategy in the hedge fund universe:
- Step #1: Purchase collateralized debt obligations (CDOs) that pay an interest rate over and above the cost of borrowing. In this instance 'AAA' rated tranches of subprime, mortgage-backed securities were used.
- Step #2: Use leverage to buy more CDOs than you can pay for with capital alone. Because these CDOs pay an interest rate over and above the cost of borrowing, every incremental unit of leverage adds to the total expected return. So, the more leverage you employ, the greater the expected return from the trade.
- Step #3: Use credit default swaps as insurance against movements in the credit market. Because the use of leverage increases the portfolio's overall risk exposure, the next step is to purchase insurance on movements in credit markets. These "insurance" instruments are called credit default swaps, and are designed to profit during times when credit concerns cause the bonds to fall in value, effectively hedging away some of the risk.
- Step #4: Watch the money roll in. When you net out the cost of the leverage (or debt) to purchase the 'AAA' rated subprime debt, as well as the cost of the credit insurance, you are left with a positive rate of return, which is often referred to as "positive carry" in hedge fund lingo.
In instances when credit markets (or the underling bonds' prices) remain relatively stable, or even when they behave in line with historically based expectations, this strategy generates consistent, positive returns with very little deviation. This is why hedge funds are often referred to as "absolute return" strategies.
Can't Hedge All Risk
However, the caveat is that it is impossible to hedge away all risk because it would drive returns too low. Therefore, the trick with this strategy is for markets to behave as expected and, ideally, to remain stable or improve.
Unfortunately, as the problems with subprime debt began to unravel the market became anything but stable. To oversimplify the Bear Stearns situation, the subprime mortgage-backed securities market behaved well outside of what the portfolio managers expected, which started a chain of events that imploded the fund.
First Inkling of a Crisis
To begin with, the subprime mortgage market had recently begun to see substantial increases in delinquencies from homeowners, which caused sharp decreases in the market values of these types of bonds. Unfortunately, the Bear Stearns portfolio managers failed to expect these sorts of price movements and, therefore, had insufficient credit insurance to protect against these losses. Because they had leveraged their positions substantially, the funds began to experience large losses.
Problems Snowball
The large losses made the creditors who were financing this leveraged investment strategy uneasy, as they had taken subprime, mortgage-backed bonds as collateral on the loans. The lenders required Bear Stearns to provide additional cash on their loans because the collateral (subprime bonds) was rapidly falling in value. This is the equivalent of a margin call for an individual investor with a brokerage account. Unfortunately, because the funds had no cash on the sidelines, they needed to sell bonds in order to generate cash, which was essentially the beginning of the end.
Demise of the Funds
Ultimately, it became public knowledge in the hedge fund community that Bear Stearns was in trouble, and competing funds moved to drive the prices of subprime bonds lower to force Bear Stearns' hand. Simply put, as prices on bonds fell, the fund experienced losses, which cause it to sell more bonds, which lowered the prices of the bonds, which caused them to sell more bonds - it didn't take long before the funds had experienced a complete loss of capital.
The Mistakes Made and Conclusion
The Bear Stearns fund managers' first mistake was failing to accurately predict how the subprime bond market would behave under extreme circumstances. In effect, the funds did not accurately protect themselves from event risk.
Moreover, they failed to have ample liquidity to cover their debt obligations. If they'd had the liquidity, they wouldn't have had to unravel their positions in a down market. While this may have led to lower returns due to less leverage, it may have prevented the overall collapse. In hindsight, giving up a modest portion of potential returns could have saved millions of investor dollars.
Furthermore, it is arguable that the fund managers should have done a better job in their macroeconomic research and realized that subprime mortgage markets could be in for tough times. They then could have made appropriate adjustments to their risk models. Global liquidity growth over recent years has been tremendous, resulting not only in low interest rates and credit spreads, but also an unprecedented level of risk taking on the part of lenders to low-credit-quality borrowers.
Since 2005, the U.S. economy has been slowing as a result of the peak in the housing markets, and subprime borrowers are particularly susceptible to economic slowdowns. Therefore, it would have been reasonable to assume that the economy was due for a correction.
Finally, the overriding flaw for Bear Stearns was the level of leverage employed in the strategy, which was directly driven by the need to justify the utterly enormous fees they charged for their services and to attain the potential payoff of getting 20% of profits. In other words, they got greedy and leveraged the portfolio to much.
The fund managers were wrong. The market moved against them, and their investors lost everything. The lesson to be learned, of course, is not to combine excessive derivatives leverage and greed.
2. CASE: THE FALL OF BARINGS BANK
Background Note:
Barings was founded in 1762, by Francis Baring who set up a merchant banking business in Mincing Lane in London, UK. The business grew rapidly during the period 1798 to 1814.
It became one of the most influential financial houses during the 1830s and 1840s. The British government paid Barings commissions to raise money to finance wars against the US and France during the mid 1800s.
During 1860-1890, Barings raised $500 mn for the US and Canadian governments and was regarded as London's biggest 'American House.' Barings was also involved in providing loans to Argentina during this period. In 1890, Barings was on the verge of bankruptcy when Argentina defaulted on bond payments. However, the Bank of England and several other major banks in London came forward to bail out the bank.
This crisis had a major impact on Barings and led the bank to withdraw all its business on the North American continent. Barings then took up the business of providing consultancy to small firms and wealthy people, including the British royal family.
Barings advised the royal family on the management of their assets, and also gave advice to small British firms on investing in stocks and bonds. For the next several decades, the bank grew well and earned significant profits. In the 1980s, the bank started operating in the US again. In 1984, Barings acquired the stock broking arm of Henderson Crosthwaite,5 which later became BSL.
Prior to its merger with the banking business (Baring Brothers & Company) in 1993, BSL was run as a separate company Incorporated in September 1986, BFS held a non-clearing membership6 of SIMEX.
FALL OF BARINGS BANK
On February 26, 1995, Barings Bank (Barings) - the United Kingdom's (UK) oldest and one of its most reputed banks - declared it was bankrupt.
The bank with a total net worth of $900 mn had suffered losses in excess of $1 bn.
These losses were result of the gross mismanagement of the bank's derivatives trading operations by Nicholas William Leeson (Leeson), the General Manager of Barings Future in Singapore (BFS).
BFS had been established to look after the bank's Singapore International Monetary Exchange (SIMEX) trading operations. Leeson's job was to make arbitrage profits by taking the advantage of price differences of similar contracts on the SIMEX (Singapore) and Osaka stock exchanges.
In spite of not having the authority, he traded in options and maintained un-hedged positions. He acted beyond the scope of his job, and was able to conceal his unauthorized derivatives trading activities.
Due to the senior management's carelessness and lack of knowledge of derivatives trading, the bank landed up in a major financial mess.
Events Leading to the Fall:
Soon after joining BSL, Leeson applied and got a transfer to Jakarta, Indonesia. Due to his excellent performance, Barings management promoted Leeson to General Manager of BFS in Singapore in April 1992.
In BFS, Leeson's job was to leverage on the arbitrage opportunities on similar equity derivatives between SIMEX and the Osaka stock exchange (OSE). To take the advantage of the arbitrage opportunity, Leeson had to adopt the following strategy - if Leeson was long on the OSE, he had to be short twice the number of contracts on SIMEX . The arbitrage trading strategy required Leeson to buy at a lower price on one exchange and sell simultaneously at a higher price on the other, reversing the trade when the price difference had narrowed or become zero. The market risk in arbitrage was minimal because positions were always matched. Leeson was not given any authority to trade in options or maintain any overnight un-hedged positions.
Industry analysts felt that the fall of Barings served as a classic example of poor risk management practices. The bank had completely failed to institute a proper managerial, financial and operational control system.
Due to the lack of effective control and supervision, Leeson got an opportunity to conduct his unauthorized derivatives trading activities and was able to reduce the likelihood of their detection.
CONCLUSION AND END RESULT:
The fall of Barings not only shocked the financial markets world over, it also exposed their vulnerability. On February 26, 1995, Barings was declared insolvent under the UK Insolvency Act, 1986.
Administrators were appointed to take control of the assets of the bank and its subsidiaries. A week later, all the assets and liabilities of Barings Bank and its subsidiaries (except BFS) were acquired by the Internationale Nederlanden Groep NV (ING).
ING was looking to expand its investment banking business especially in Asia, where Barings had an extensive business network involving merchant banking activities such as investment banking, corporate banking, venture capital and capital markets operations, together with securities trading and asset management. ING paid one pound for Barings and took on the responsibility of paying the entire $1 bn debts that Barings had accumulated.
Thus, we saw how unregulated exposure to trading in derivatives caused huge losses in Barings Bank which ultimately led to its downfall.
3. CASE OF A FALLING GIANT: AIG
What was once the unthinkable occurred on September 16, 2008. On that date, the federal government gave the American International Group - better known as AIG - a bailout of $85 billion. In exchange, the U.S. government received nearly 80% of the firm's equity. For decades, AIG was the world's biggest insurer, a company known around the world for providing protection for individuals, companies and others. But in September, the company would have gone under if it were not for government assistance.
EVENTS LEADING TO THE FALL
High Flying
The epicenter of the near-collapse of AIG was an office in London. A division of the company, entitled AIG Financial Products (AIGFP), nearly led to the downfall of a pillar of American capitalism. For years, the AIGFP division sold insurance against investments gone awry, such as protection against interest rate changes or other unforeseen economic problems. But in the late 1990s, the AIGFP discovered a new way to make money.
A new financial tool known as a collateralized debt obligation (CDO) became prevalent among large investment banks and other large institutions. CDOs lump various types of debt - from the very safe to the very risky - into one bundle. The various types of debt are known as tranches. Many large investors holding mortgage-backed securities created CDOs, which included tranches filled with subprime loans. The AIGFP was presented with an option. Why not insure CDOs against default through a financial product known as a credit default swap. The chances of having to pay out on this insurance were highly unlikely, and for a while, the CDO insurance plan was highly successful. In about five years, the division's revenues rose from $737 million to over $3 billion, about 17.5% of the entire company's total.
One large chunk of the insured CDOs came in the form of bundled mortgages, with the lowest-rated tranches comprised of subprime loans. AIG believed that what it insured would never have to be covered. Or, if it did, it would be in insignificant amounts. But when foreclosures rose to incredibly high levels, AIG had to pay out on what it promised to cover. This, naturally, caused a huge hit to AIG's revenue streams. The AIGFP division ended up incurring about $25 billion in losses, causing a drastic hit to the parent company's stock price. Accounting problems within the division also caused losses. This, in turn, lowered AIG's credit rating, which caused the firm to post collateral for its bondholders, causing even more worries about the company's financial situation.
It was clear that AIG was in danger of insolvency. In order to prevent that, the federal government stepped in. But why was AIG saved by the government while other companies affected by the credit crunch weren't? Too Big To Fail
Simply put, AIG was considered too big to fail. An incredible amount of institutional investors - mutual funds, pension funds and hedge funds - both invested in and also were insured by the company. In particular, many investment banks that had CDOs insured by AIG were at risk of losing billions of dollars. For example, media reports indicated that Goldman Sachs had $20 billion tied into various aspects of AIG's business, although the firm denied that figure.
Money market funds - generally seen as very conservative instruments without much risk attached - were also jeopardized by AIG's struggles, since many had invested in the company, particularly via bonds. If AIG was to become insolvent, this would send shockwaves through already shaky money markets as millions of investors - both individuals and institutions - would lose cash in what were perceived to be incredibly safe holdings. However, policyholders of AIG were not at too much risk. While the financial-products section of the company was facing extreme difficulty, the vastly smaller retail-insurance components were still very much in business. In addition, each state has a regulatory agency that oversees insurance operations, and state governments have a guarantee clause that will reimburse policyholders in case of insolvency.
While policyholders were not in harm's way, others were. And those investors - from individuals looking to tuck some money away in a safe investment to hedge and pension funds with billions at stake - needed someone to intervene.
Stepping In
While AIG hung on by a thread, negotiations were taking place among company and federal officials about what the next step was. Once it was determined that the company was too vital to the global economy to be allowed to fail, the Federal Reserve struck a deal with AIG's management in order to save the company.
The Federal Reserve was the first to jump into the action, issuing a loan to AIG in exchange for 79.9% of the company's equity. The total amount was originally listed at $85 billion and was to be repaid over two years at the LIBOR rate plus 8.5 percentage points. However, since then, terms of the initial deal have been reworked. The Fed and the Treasury Department have loaned even more money to AIG, bringing the total up to an estimated $150 billion.
Conclusion
AIG's bailout has not come without controversy. Some have criticized whether or not it is appropriate for the government to use taxpayer money to purchase a struggling insurance company. In addition, the use of the public funds to pay out bonuses to AIG's officials has only caused its own uproar. However, others have said that, if successful, the bailout will actually benefit taxpayers due to returns on the government's shares of the company's equity.
No matter the issue, one thing is clear. AIG's involvement in the financial crisis was important to the world's economy. Whether the government's actions will completely heal the wounds or will merely act as a bandage remedy remains to be seen.
4. CASE : Long Term Capital Management (LTCM)
Summary
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.
Overview
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.
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.
Events
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.
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"
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.
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. 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.
Analysis and Conclusive findings:
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. 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 Ripple 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.
CONCLUSION
Derivatives remain a type of financial instruments that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by investing in a Mutual Fund whose underlying assets may include derivative products. Even, the financial derivatives have changed the face of finance by creating new ways to understand, measure and manage financial risks.
The lessons to be learned from this current crisis of derivatives are:
Ø Market values matter for leveraged portfolios.
The firms, in the cases mentioned above, depended on exploiting deviations in market value from fair value. And it 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.
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 seen in this case, 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.
In other words, you can take liquidity bets, but you cannot leverage them much.
Ø Liquidity itself is a risk factor.
As explained in the cases above, most of these firms fell victim to a flight 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. 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.
Using this approach, these firms 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.
Ø Models must be stress-tested and combined with judgement.
Another key lesson to be learnt from these debacles 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.
Ø Financial institutions should aggregate exposures to common risk factors.
One of the other lessons to be learned is that it is important to aggregate risk exposures across businesses.
As seen in our analysis of the Long Term Capital Management (LTCM)case, 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.
Financial derivatives should be considered for inclusion in any organisation’s risk-control arsenal. Using derivatives allows risk to be broken into pieces that can be managed independently. The viability of financial derivatives rests on the principle of comparative advantage i.e. the relative cost of holding specific risks. Whenever comparative advantage exists, trade can benefit all parties involved. From a market-oriented perspective financial derivatives offer free trading of individual risk components. As there is always an other side of the coin, derivatives also have a darker side. As we have seen, organisations like Bear Stearns, Washington Mutual, Barings Bank, etc. experienced huge losses from derivatives trading. Barings Bank lost around $1 billion just because one trader whose job was to carry out low risk arbitrage switched from being an arbitrageur to a speculator. The hedge fund named Long Term Capital Management lost about $4 billion in 1998. The treasury department of Procter & Gamble lost about $90 million trading highly exotic interest rate derivatives contracts. These losses warn the users against excessive use of financial derivatives. Without a clearly defined risk management strategy, excessive use of financial derivatives can be risky. They can cause serious losses and can threaten the firm’s long-term objectives. Hence it is important that users of derivatives fully understand the complexity of financial derivative contracts and accompanying risks. Derivatives being an important risk management tool necessitate its users to understand the intended function and the safety precautions before being put to use. The use of derivatives should be integrated into an organisation’s overall risk-management strategy and should be in harmony with its objectives. Hence the users of derivatives can use these instruments for their benefit and for the benefit of the society at large.
