Duffie krishnamurthy reinhart lehman


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Duffie krishnamurthy reinhart lehman

  1. 1. Failure Mechanics of Dealer Banks (Duffie, 2010)<br />
  2. 2. Failure Mechanics of Dealer Banks (Duffie, 2010)<br />What do they do?<br />Securities dealing, underwriting and trading.<br />OTC derivatives.<br />Prime brokerage and asset management.<br />Who are they?<br />
  3. 3. Securities Dealing, Underwriting and Trading<br />What do they do?<br />Origination<br />Market making<br />Both finance with and make markets for repos.<br />
  4. 4. Repurchase Agreements<br />Structure:<br />Collateral:<br />Borrower<br />Lender<br />Zero Haircut<br />
  5. 5. Repurchase Agreements<br /><ul><li>> $4 trillion daily turnover (SIFMA factsheet).</li></ul>In 2008, top U.S. investment banks funded roughly half of their assets with repo (Hordahl and King (2008) cited in Gorton (2010, “Haircuts”).<br />Overall size of market in 2008 estimated by Gorton at $12 trillion.<br />U.S. Banking System assets ~ $10 trillion.<br /><ul><li>Default protection stems from nondefaulting party ability to unilaterally terminate the agreement and sell the collateral or keep “borrowed” money.</li></ul>This means that repo transactions are excluded from US Bankruptcy Code.<br /><ul><li>Haircut provides additional protection.</li></ul>E.g., Accept $100m collateral for $90m cash (loan) = 10% haircut.<br />Remember, borrower also pays “interest” on $100m.<br /><ul><li>Tri-party repos ($2.5 trillion in 2008) include a clearing bank (predominantly JPM & BoNY) to hold collateral and is responsible for returning cash to creditor.
  6. 6. Lender can reuse collateral, say, against a derivatives position. This is referred to as rehypothecation.</li></li></ul><li>OTC Derivatives<br />Notional value outstanding ~$600 trillion (vs $400 trillion for exchange-traded derivatives).<br />Largest dealer: JP Morgan ~$80 trillion.<br />Majority of activity in interest-rate swaps.<br />~$342 trillion in June 2009 (BIS) w/ mkt value ~$13.9t (table 21A, single currency).<br />Market Value not Notional Value (Table 19, all)<br />
  7. 7. OTC Derivatives: Contracts and Default Protection<br />International Swaps and Derivatives Association (ISDA) sets standards for Master Swap Agreements.<br />Legally combines trades between a given pair of counterparties.<br />Enables netting in the event of default.<br />Sets collateral requirements.<br />Recalculated daily and netted across contracts with same counterparty.<br />Sets obligations in the event that one party defaults.<br />The London arm of Lehman alone had about 8,000 ISDA Master Agreements in place encompassing about 67,000 trades when it went down.<br />Failure exposed legal weaknesses in the master agreements. <br />http://www.mayerbrown.com/publications/article.asp?id=8431&nid=6<br />
  8. 8. Prime Brokerage & Asset Management<br />Business is highly concentrated.<br />In 2007 about 2/3 of business done by 3 banks (MS, GS, BS (JPM)).<br />Pre-crisis: Clients often concentrated their business with one prime broker.<br />What do they do?<br />Manage securities holdings.<br />Clearing (even more highly concentrated – JPM, BoNY).<br />Cash management.<br />Securities lending and financing.<br />Derivatives counterparty.<br />In addition to fees, prime brokers earn revenue by lending securities owned by prime brokerage clients.<br />
  9. 9. Failure Mechanisms<br />Inability to renew repo financing >>> asset fire sales.<br />Remember share of collateral accounted for by MBS.<br />We’ll examine this channel more closely (see Krishnamurthy).<br />Comingling of client and prime broker cash and securities.<br />Enables use of one clients cash deposit to fund loan to another.<br />Greater scope for this in London than in U.S.<br />(Margin) loans to clients can be financed through re-hypothecation of the client’s securities.<br />E.g., Prime broker uses client securities (held by prime broker) as collateral on a secured loan for itself. Then lend (some of) proceeds to client.<br />Can also use proceeds for own purposes.<br />Regulation permits use of up to $140 of client assets as security for each $100 of margin cash lending. <br />What if client withdraws cash (or securities)?<br />What if client demands financing as condition for leaving securities with prime broker?<br />
  10. 10. Failure Mechanisms (cont.)<br />Derivatives counterparties will look for opportunities to reduce exposure to a prime broker at risk of solvency crisis.<br />Borrow from the dealer.<br />Enter new trade requiring a cash payment.<br />Attempt to harvest cash from in-the-money trades.<br />Dealer sends negative signal if it will not cooperate.<br />Counterparty attempts to novate exposure to another dealer could be refused (e.g., Bear Stearns) and thereby send a negative signal about original dealer.<br />Demand additional collateral for credit downgrade (e.g., AIG).<br />Force early termination in a default event:<br />Demand replacement cost of contract.<br />Most OTC contracts are exempted from the automatic stay at bankruptcy – this encourages other creditors to run or refuse to provide financing before default.<br />
  11. 11. Failure Mechanisms (cont.)<br />Refusal of clearing bank to process dealer’s transactions.<br />Under ordinary circumstances, clearing banks extend overdraft privileges within the day to avoid the dealer having to deposit excess cash or settle up at every trade.<br />Once the clearing bank exercises its “right to offset,” the dealer’s trading operation is dead.<br />
  12. 12. Krishnamurthy: Debt Market Malfunction<br />Risk capital diminished.<br />Repo haircuts rose.<br />Counterparty risk increased.<br />Together these caused sharp decline in liquidity.<br />Declining liquidity limits arbitrage and therefore leads to prices being disconnected to fundamentals.<br />
  13. 13. Debt Markets<br />Krishnamurthy notes $18.64 trillion in loans and securities but note that asset-backed securities are just a conduit for funding the underlying loans. <br />Subtract securitizations from loans $10.8t – $7.84t + $0.6t = $3.56t.<br />Thus suggests about 2/3 of loans were funded indirectly through securitizations.<br />But remember securitizations of securitized tranches… <br />
  14. 14. Diminished Risk Capital<br />These losses underestimate decline in risk capital.<br />For example, hedge funds lost more because of redemptions. <br />Substantial systemic decline is risk capital increases risk aversion so that asset prices fall, causing risk capital to decline further…<br />
  15. 15. Repo Financing and Haircuts<br />Financial institutions (like all firms) raise new equity infrequently.<br />However, as we’ve argued repeatedly, external capital is especially expensive for financial firms.<br />Most meet day-to-day needs with repo financing.<br />Relative liquidity of the assets they hold enables this form of financing. <br />Repo financing requires equity in the sense that the lender imposes a “haircut” on the lender.<br />2.5% haircut implies ability to borrow $97.50 against $100 worth of assets.<br />This form of financing, however, is very sensitive to the size of the haircut because it’s rolled over frequently and haircuts increase at precisely the times when it would be most difficult to raise new equity.<br />
  16. 16. Repo Financing and Haircuts<br />Suppose the haircut doubled from 2.5% to 5%. If the borrower’s equity is fixed (in the short term), the borrower would have to liquidate half of its assets being funded with repo.<br />If I only have $2.50 in equity, I can finance $100 of assets at a 2.5% haircut but only, $50 of assets at a 5% haircut (0.05*50 = $2.50 equity plus $47.50 in repo funding). <br />The sharp increase in haircut rates during the financial crisis forced extreme, rapid reduction in the size of financial firms’ balance sheets.<br />
  17. 17. Repo Financing and Haircuts<br />What caused the sharp increase in repo haircuts?<br />Two primary considerations:<br />Borrower default probability.<br />Recovery rates in the event of default.<br />The second consideration was especially important for financing of relatively illiquid assets like mortgage and asset-backed securities.<br />As the perceived threat of default rose, so did the real threat of default.<br />Absence of financing forced asset sales.<br />Sales of illiquid assets further strained liquidity and asset valuations.<br />Note the sharp increase in spreads over Treasury haircut rates. <br />
  18. 18. Repo Financing and Haircuts<br />Rising haircuts caused repo market to shrink.<br />This figure only reflects decline in repo on high quality collateral!<br />For lower quality collateral, the financing channel essentially closed.<br />
  19. 19. Counterparty Risk<br />Trilateral agreements can diminish counterparty risk but in a crisis default risk can rise systemically among counterparties.<br />Even banks that were strong counterparties can become weak counterparties.<br />
  20. 20. Counterparty Risk<br />Five-year credit default swaps implied a 60% probability of default expectation for Morgan Stanley.<br />Why was BofA’s (and even Citi’s) swap rate relatively stable? <br />
  21. 21. Flight to Liquidity<br />Declining risk capital, rising repo haircuts, and increased counterparty risk caused a flight to liquidity.<br />The price of illiquid assets fell relative to the price of liquid assets.<br />E.g., see spreads between FNMA Bonds and Treasury Bonds.<br />2008: 140 bps<br />Average for 1958-2004: 38 bps<br />The desire for greater liquidity favored shorter-term securities over longer-term securities. <br />But shorter term financing is riskier.<br />Borrowers will be less inclined to invest.<br />
  22. 22. Price Effects on Debt Securities<br />Illiquidity weakens arbitrage linkage of fundamental and market prices.<br />Not surprising that swap rates fell but the negative swap spread is (extremely) troubling – this is an arbitrage opportunity.<br />
  23. 23. Reinhart: Could the regulators have done better?<br />Why rescue Bear Stearns and not Lehman?<br />
  24. 24. The Lehman Bankruptcy: Valukas Report<br />The U.S. Bankruptcy Court for the Southern District of New York appointed an examiner, Anton R. Valukas, to produce a report detailing the events leading to the Lehman bankruptcy.<br />Valukis delivered a 2,200 page report on March 11, 2010.<br />Most of the information that follows is excerpted from the report.<br />See the highlighted excerpt containing the “Examiner’s Conclusions” for more detail.<br />“Lehman’s business model was not unique…”<br />“Lehman’s financial plight was exacerbated by…”<br />Lehman executive conduct ranging from errors of business judgment to balance sheet manipulation;<br />A business model that rewarded excessive risk taking and leverage;<br />Maintained $700b of assets (mostly long-term) and corresponding liabilities (mostly short-term) with $25b capital<br />Government agencies who might better have anticipated or mitigated the outcome.<br />
  25. 25. Lehman’s Strategic Shift<br />“In 2006, Lehman made the deliberate decision to embark upon an aggressive growth strategy, to take on significantly greater risk, and to substantially increase leverage on its capital… Lehman was slow to recognize the developing storm… Rather than pull back, Lehman made the conscious decision to “double down.” hoping to profit from a counter-cyclical strategy. As it did so, Lehman significantly and repeatedly exceeded its own internal risk limits and controls.” (Examiner’s Report, p.4)<br />The business model shifted from “moving” (originate to distribute) to “storage” (using balance sheet for proprietary risk taking).<br />Lehman increased net assets by ~128b (48%) from the fourth quarter of 2006 through the first quarter of 2008.<br />Increases in net assets primarily attributable to accumulation of illiquid assets. <br />
  26. 26. Lehman Liquidity Risk<br />End of 2nd Quarter 2008: Lehman maintained $105b of non-government, non-agency (collateralized) repo financing.<br />Collateral Type:<br />Asset Backed (Investment Grade) $24.5b<br />Asset Backed (Non-Investment Grade) 2.0<br />Convertibles (Investment Grade) 1.5<br />Convertibles (Non-Investment Grade) 2.3<br />Corporate (Investment Grade) 12.8 <br />Corporate (Non-Investment Grade) 8.2<br />Emerging Market Bonds 7.1<br />Equities 23.4 <br />Money Markets 7.3<br />Municipals 2.2<br />Private Label (High Yield) 2.3<br />Private Label (Investment Grade) 9.9<br />Residential Whole Loan 1.1 <br />42% funded with overnight repo.<br />19% of repo had term less than 2 weeks.<br />60% of the book reflected assets unacceptable to central banks for collateral purposes. <br />Much of this collateral had limited liquidity.<br />
  27. 27. Lehman Liquidity Risk<br />
  28. 28. Lehman Management<br />Senior management regularly disregarded or overruled risk controls.<br />See appendix below for risk management function and SEC oversight.<br />Excluded certain risky investments from stress tests.<br />2008 tests indicated large proportion of tail risk in exclusions.<br />Did not strictly apply balance sheet limits.<br />Repo 105.<br />Treated risk appetite limit as a “soft” guideline and misrepresented it to the SEC as a meaningful constraint.<br />Did inform board of<br />Increased risk in pursuit of growth.<br />Firm-wide risk limit breaches.<br />Growing illiquidity post July 2007.<br />
  29. 29. Lehman Balance Sheet Manipulation: Repo 105<br />Repurchase requirement generally called for treatment of repo as loan<br />Accounting rules “suggested” that an exchange of securities in excess of 102% of cash value would show “lack of control” of collateral.<br />Lehman exchanged 105% of assets for cash to make the case that the assets could be removed from balance sheet.<br />Had difficulty finding an accounting firm to sign off because it was clear that they were using this for the purpose of shrinking the reported balance sheet (and leverage ratio) just prior to quarterly reporting and then buying back the assets after reporting.<br />
  30. 30. Regulatory Oversight of Lehman Liquidity<br />In mid-March 2008 (following Bear Stearns collapse) the SEC and NY Fed placed teams in Lehman to monitor Lehman’s financial position with particular focus on liquidity. (ER, p.8).<br />Lehman did not publicly disclose that by June 2008 a significant part of its reported liquidity pool had become difficult to monetize.<br />From June on, Lehman included in liquidity report substantial cash and securities on deposit with clearing banks.<br />They had technical right to recall these deposits but doing so would likely have impaired ability to continue clearing business.<br />x<br />
  31. 31. Appendix<br />Lehman’s Risk Management Function.<br />What’s in Repo 105.<br />Examples of Fallout from Bankruptcy Filing.<br />
  32. 32. Lehman’s Risk Management Function<br />Widely regarded as among the best.<br />Market risk management<br />Changes in market rates, prices, and volatilities<br />Interest rates, equity prices and foreign exchange rates<br />Risk managers present on trading floors<br />Credit risk management<br />Operational risk management <br />Quantitative risk management<br />Responsible for risk quantification and review and approval of pricing models <br />Sovereign risk management <br />Investment management division risk management<br />
  33. 33. Lehman’s Risk Metrics & Limits <br /><ul><li>VaR: 1 day, 95%, Limits set at firm, division, business line and regional levels.
  34. 34. Risk appetite: Given greater emphasis. Reviewed monthly with SEC.</li></ul>Amount prepared to lose over 1yr due to mkt, event, & credit.<br />Largest revenue reduction tolerated without compensationinadequacy, rating downgrade, or loss of confidence in firm.<br />Well regarded by SEC and rating agencies for comprehensiveness.<br />Limits set firm wide cascading down to divisions and business lines.<br />Reported to SEC when limits exceeded. <br />Stress/scenario testing: How much could firm lose in plausible if unlikely scenario. Used to capture tail/outlier events in market.<br />Report results to SEC monthly under CSE Framework.<br />Also required supplement to VaR under Basel II/Accord.<br />FSA stipulated its own stress testing requirements.<br />Horizons reflected liquidity of instruments/positions.<br />Equity adequacy, liquidity controls. Both internally and externally established.<br />External: SEC CSE Framework for total capital ratio.Minimum of 10% total capital ratio. <br />Internal: Risk Equity and Equity Adequacy Framework.Risk equity used to allocate equity to each business.EAF calculates equity required to restructure in crisis.Give sufficient time for asset disposition and liability restructuring.Viewed as best measure of equity sufficiency by Lehman.<br />Cash Capital Model measured liquidity & funding capacity for illiquid positions. Assumed unable to access unsecured debt market and limited secured funding during liquidity events.<br />Transaction limits: Aimed primarily at rating agencies and applied to leveraged lending. Notional limit of 15% intended to correspond with commercial bank tangible equity. Closely watched by rating agencies.<br />Balance sheet limits: restrict amount of assets originated in a ¼ by division or business line. Limit related to return on assets.<br />FID consistently exceeded limits despite decreasing returns.Limit breaches concentrated in securitized products & real estate.Breaches led to penalties but FID effectively negotiated relaxation. <br />