Introduc)ontoALM

WhyALM?
Insurancecompaniesusedtotreatassetsand liabili2esseparately.
Thiscanbeproblema2cwithproductsthatare sensi2vetointerestratesand/ormarketreturns.
Forexample,variableannui2es,productswith guarantees.

Therehavealsobeenhugefailuresbybanks (Barings,BearStearns).
Thesehaveledto(evolving)stricterregula2ons w.r.t.capitalrequirements.

WhyALM?
ALMtriestoaddressnancialrisksinan integratedmanner. Inpar2cular,itisconcernedwith:
MarketRisk CreditRisk Opera2onalRisk Underwri2ngRisk

Wewillmainlyfocusonthersttwo.

MarketRisk
Stockmarketpricerisk Commoditypricerisk Interestraterisk Foreignexchangeraterisk Creditrisk Liquidityrisk Vola2lityrisk

CreditRisk
Riskoflossduetocreditevents,thechanging creditworthinessofobligors,counterpar2es,and en22esreferencedincreditderiva2ves. Default,migra2on,creditspreadmovements. Examples:
Defaultofabondyouhold(obligor/issuerrisk) Defaultofacounterpartytoanoverthecounter deriva2vecontract(counterpartycreditrisk) LehmanBrothersdefaultsonitsdebt,whenyouhave soldinsuranceagainstitsdefault(youarethe protec2onselleronacreditdefaultswap).

Opera)onalRisk
"Opera2onalriskisdenedastheriskofloss resul2ngfrominadequateorfailedinternal processes,peopleandsystems,orfrom externalevents.Thisdeni2onincludeslegal risk,butexcludesstrategicandreputa2onal risk"(BIS) Alsoincludesmodelrisk(riskofusingan inappropriateormisspeciedmodel).

ExamplesofOpera)onalRisk
Fraud(e.g.Barings) ITfailures FailuresinseUlementsoftransac2ons
HerstaUBank(1974)

Earthquakes(e.g.Barings) "Rogue"traders(Barings,SocGen,)

Underwri)ngRisk
Riskoflossduetoafailureofunderwri2ng standardsforinsuranceproducts.
Riskthatpremiumswillnotfutureincurredlosses.

Thetermunderwri2ngriskisalsosome2mes usedtorefertotheriskoffailureof underwri2ngstandardsforloans(e.g.NINJA loans).

ExamplesofALMFailures
NissanMutualLife:Oeringindividual annui2esat5%5.5%,inves2ngassetsin governmentbonds.
Japanesegovernmentbondyieldsdroppedto recordlowlevels. Thewidegapbetweenpromisedreturnon liabili2esandassetreturncausedthecompanyto gobankrupt.

ExamplesofALMFailures
Wewillbrieyexaminetherecentnancialcrisis, withapar2cularemphasisonafundamental liquiditymismatchproblemthataectsmany nancialins2tu2ons. Odennancialins2tu2onshave:
Assetsthatarerela2velyilliquidandwithlong maturi2es. Liabili2esthatareliquid,withshortmaturi2es.

Thismismatchcancauseseverefunding problems,leadingtodefault,intheeventofa liquiditycrisis.

Example:Banks
Consideratradi2onalcommercialbank. Assets:Loans(mortgages,commercialloans, etc.)
Longmaturity,illiquid.

Liabili2es:DemandDeposits(essen2ally innitelyliquid) Thismismatchmakesbankssuscep2bleto runsontheirdeposits(e.g.bankrunsinthe 1930s).

Example:Banks
Manystepsweretakentotrytoprotectbanks againstrunsontheirdeposits:
Depositinsurance Minimumcapitalrequirements Lenderoflastresort(e.g.theFederalReservein theU.S.,BankofCanada) Bailouts(Greenspanput)

Example:BearStearns
5thlargestinvestmentbankintheU.S. WentbankruptaderafundingcrisisinMarch 2008. EndedupsellingitselftoJ.P.Morganfor$10per share.
Upfromtheoriginaldealof$2pershareaderBear shareholdersthreatenedtosue.(Openingpriceon Friday,March14,2007:$62pershare). Addi2onalhelpfromtheFederalReserve,which guaranteed$29billioninmortgagerelatedassets.

BearStearnsStockPrice

BearStearns
BearStearnsisaninvestmentbank,makesits moneymainlyfrom:
Proprietarytradingac2vi2es(heavilyinvestedin mortgageassets).
Primarilyfundedbyshorttermborrowing(i.e.repomarket) Highlyleveraged(leveragera2oofaround30).

Servicestocorporateclients(investmentadvising services,nancialunderwri2ngservices) Primebrokeragefees(holdingsecuri2esand implemen2ngtradesforhedgefunds).

BearStearns
Noteagainthemismatchbetween LongTerm,Illiquidassets:
Investmentporloliosconsis2ngofoverthe counterderiva2ves(e.g.mortgageporlolio) Physicalassets(e.g.buildings)

ShortTerm,LiquidLiabili2es:
Primebrokerageaccounts Shorttermfundingnancingtradingac2vi2es.

BearStearns:Timeline
2006:Housingbubblebeginstodeate. Summer2007:Troublewithtwohedgefundsinves2ng inmortgagebackedsecuri2esandrunbyBearStearns AssetManagement.
Bearpledges3.2billiontosupportthefunds(theys2llfail). FederalreservebeginstomonitorBearsnancialposi2on

Fall2007:BearbeginstolobbyfortheFedtoactas lenderoflastresorttoinvestmentbanks(aswellas commercialbanks).

BearStearnsTimeline
December20,2007:Companyannounces expected4thquarterloss(mainlyduetowrite downsonmortgageassets). Ironically,thecompanywasduetoannounce a1stquarterprot(approximately$1/share) ontheweekofMarch17,2008.
Itnevermadeitthatfar.

BearStearnsTimeline
DuringtheweekofMarch1014,2008,BearStearns experiencedwhatwasessen2allyarunonaninvestment bank:
Marketlossofcondenceinthermsabilitytomeetshort termliabili2es(repoborrowing).
Higherinterestondebt,troublendinglenders(e.g.1yearCDS spreadgoesupto8%from5.5%,source:WSJ).

Stockpricedrops. Nervoushedgefundspulloutofprimebrokeragearrangements (ndotherinvestmentbanks). Morelossofcondenceinrmsabilitytomeetshortterm liabili2es.

Etc.(Cyclerepeatsitselfun2lrmbustsforexamplewhenitcantre nancetheshorttermliabili2esthatsupportthetradingac2vi2es).

BearStearns:SpeedoftheCollapse
BeganweekofMarch10with18.1Billionincash. ByThursdayevening,ithadonlyabout$3Billion.
Mostofthemoneythatwentout(13.9Billion)was duetolossofprimebrokerageclients. Othersignicantcashsinkswerexedincomeloans (2.5Billion),Commercialpaper(900million). LedBearwithinsucientcashtorenance.

Bookvalueofshares~$80. Source:StreetFighters,byKateKelly

TreasuryEurodollarSpread(TEDSpread)

Source:Wikipedia

Source:Wikipedia

OtherExamples
StructuredInvestmentVehiclesandAsset BackedCommercialPaper
Fees,Equity Bank Guarantees SIV (holdsrisky assets(e.g. CDOs)

Bonds ABCP

CapitalMarkets

SIVsandABCP
InvestorslosttrustinopaqueSIVswithilliquid, riskyassets. SIVcantrenewitsshorttermABCPfunding. Sponsoringnancialins2tu2onsuerslosses throughtheguarantees.

MoneyMarketFunds
AderBear,LehmanBrothers(bankruptcylingon Sept.12,2008),MerrillLynch(solditselftoBank ofAmerica). Moneymarketfundsaremeanttobesupersafe, veryliquid. Oneoftheoldestfunds,ReservePrimaryFund, hadinvestedheavilyinLehmanshorttermdebt.
Brokethebuck(wentbelowpar)inSept,2008, triggeringarunonmoneymarketfunds.

MoneyMarketFunds
Somefundshadtriedtooerhigherreturns byinves2ngasmallpor2onofassetsinilliquid securi2es.
Investorslostfaithastheydidnotknowwhatthe fundsheld,andwhowouldbenext. Runonmoneymarketfunds. FederalReserveandTreasuryhadtostepinto provideliquidityandinsurance.

HedgeFunds
Shorttermnancingbyinvestors(usuallycanpullout fundsaderashortlockoutperiod). Odenhavehighlyleveragedinvestmentsinhighly illiquidoverthecounterassets. Iffundsperformpoorly,investorscanpullouttheir money.
Distressed,illiquidassetscanonlybesoldatresale prices Posi2onssobigthataUemptedsalesaectprice. Collateralcallsforcingmorelosses,furthersales. Downwardspiral. Addi2onalnancingfromtherepomarket.

SpreadoftheCrisis
Moretradi2onalbanks(seeLIBORgraph) Corporatesector:
Commercialpaperusedforshorttermnancingby manycorporatetreasurers. Maininvestorismoneymarketfunds. Downfallofmoneymarketfundsmakesitdicultto meetworkingcapitalrequirements. FederalReservehadtocreateafacilitytopurchase corporatecommercialpaper.

Sovereigns(PIGS/Eurocrisis)

CommonThreadsintheExamples
Longterm,illiquidassets(odenopaqueto investorsand/orcounterpar2es). Liquid,shorttermliabili2es. Highleverage.

References
Kelly,K.,StreetFighters,Porlolio,2009. Acharya,V.,Philippon,T.,Richardson,M.,and Roubini,N.,TheFinancialCrisisof 20072009:CausesandRemedies,in RestoringFinancialStability:HowtoRepaira FailedSystem,Acharya,V.andRichardson,M., editors,Wiley,2009.