FMP9 - Learning from Financial Disasters Flashcards
Analyse key factors that led to and derive lessons learned from case studies involving interest rate risk, including 1980s savings and loan crisis in the US
What happened:
- s&l’s were riding yield curve getting positive spread on lendings and borrowings
- inflation sparked restrictive monetary policy and removed ceiling on what s&ls paid, meant spread was wiped out and generated negative margin due to short term funding costs
Lessons:
- firms must manage balance sheets so that shift in interest rates effects assets and liabilities similarly
Analyse key factors that led to and derive lessons learned from case studies involving funding liquidity risk, including Lehman Brothers, Continental Illinois, and Northern Rock
Lehman Brothers:
- created mortgage back securities using subprime mortgages as collateral
- housing market began to drop byt LB continued to build up business and hold mortgage-related assets as its long-term investments for its own account
- became massively leveraged and dependent on confidence in funders and counterparties
- housing bubble burst and investors lost confidence in accuracy of firms valuation of assets so demand more collateral or refused to deal, lead to bankruptcy
Continental Illinois:
- counterparty defaulted on debt which CI held for them
- CI relied heavily on federal funds to fund lending, became unable to pay so raised money in much higher interest rate markets
- CI customers spooked and withdrew $6 billion in 10 days, liquidity crisis meaning government had to step in
Northern Rock:
- aggressive expansion plan meaning they relied heavily on investors rather than depositors
- interbank lending frozen so NR couldn’t fund themselves
- news of Bank of England planning to step into help broke and run on bank ensued
Lessons:
- require sufficient liquidity and solid funding strategies
- trade off between liquidity and interest rate risk, when funding liabs have shorter duration than loan assets, more exposed to liquidity than interest rate risk
- reduce maturity of assets
Analyse key factors that led to and derive lessons learned from case studies involving implementing hedging strategies including the Metallgesellschaft case
What happened:
- tried to hedge oil futures with rolling dynamic hedge
- greatly exposed to drop in spot prices of oil (contango), which happened
Lessons:
- consider time horizon of hedges
- must be appropriately implemented
Analyse key factors that led to and derive lessons learned from case studies involving model risk, including the Nierderhoffer case, Long Term Capital Management, and the London Whale case
Niederhoffer:
- Wrote large quantities of uncovered puts on the S&P thinking 5% drop in stock market would be rare
- 7% drop happened and liquidity dried up, firm was unable to meet obligations so positions liquidated
LTCM:
- hugely leveraged in low risk positions on corporate bonds (arbitrageurs)
- were not able to predict dramatic increase in correlations and volatilities (their trading models were not robust enough)
- sharp drop in liquidity brought margin calls on future holdings
Lessons:
- a strategy producing small returns over time still has a small probability of a major loss
Analyse key factors that led to and derive lessons learned from case studies involving rogue trading and misleading reporting, including the Barings case
Barings:
- trader used position to build large speculative positions and hid large losses from this
- losses were reported as profits and became so large bank was forced to liquidate
Lessons:
- reporting and monitoring of trades must be separated from traders
- consistent and large profits should be investigated
Analyse key factors that led to and derive lessons learned from case studies involving financial engineering and complex derivatives, including Bankers Trust, the Orange County case, and Sachsen Landesbank
Orange County:
- leveraged $12b and bought complex notes
- market conditions changed and lost $1.5b and forced into bankruptcy, caused by excessive leverage
BT:
- convinced two companies into complex interest rate swap
- both sued for misrepresenting the risk in the swap after huge losses
Sachsen:
- expanded to hold large volumes of US MBS
- positions were too large compared to balance sheet and when subprime mortgage crisis hit, Sachsen had to be sold
Lessons:
- firms must understand risks in their business models
- appropriate risk management in line with risk appetite required
Analyse key factors that led to and derive lessons learned from case studies involving reputational risk, including the Volkswagen case
What happened:
- programmed emissions controls to only be activated during regulatory testing and thus passed tests but were actually much worse
- when admitted, lost a third of its share price
Analyse key factors that led to and derive lessons learned from case studies involving corporate governance, including the Enron case
What happened:
- squeezed prices of electricity so other businesses failed
- senior management acted in own interests and falsified financial reports
Lessons:
- appropriate corporate governance needs to be in place
Analyse key factors that led to and derive lessons learned from case studies involving cyber risk, including the SWIFT case
- Hackers sent fake messages instructing funds to be move from Bangladesh Bank to fake accounts then deleted database record of the transfer
Shows need for safe systems
