Liquidity Risk Case Studies - Lehman Brothers, Continental Illinois, and Northern Rock

 Liquidity Risk 

• Liquidity risk is the risk that an entity might not be able to meet short-term cash requirements. 
• This risk can materialize from external market conditions, from internal operational issues, from structural (i.e., balance sheet) challenges, or from a mix of these three

Lehman Brothers

• In the early 2000s, it invested heavily in securitized U.S. real estate assets. 
• This company was very active in the process of sourcing loans, repackaging them as securitized assets, and selling them to investors.
• All banks use leverage where they source new assets (i.e., loans or securitized loan products) and often use debt to fund the new assets rather than customer deposits or internal capital. By 2007, Lehman Brothers had leverage (an asset-to-equity ratio) of 31:1.
• Its core funding strategy was to borrow in the short-term (i.e., daily repo) markets and use these short-term borrowings to fund the long-term and relatively illiquid securitized assets.
• The housing bubble had clearly burst by the second half of 2007, and investors became increasingly unwilling to lend Lehman (and other market participants) money in the short-term markets.
• On September 15, 2008, Lehman Brothers was forced to file for bankruptcy.

Continental Illinois

• In the late 1970s, the bank was one of the big players in the oil and gas market
• Another bank (Oklahoma-based Penn Square Bank) was actively sourcing oil and gas loans from the Oklahoma natural resources exploration industry. 
• Penn Square could handle small loans, but it sent all larger deals to a partner such as Continental Illinois, which was one of the 10 largest banks in the United States.
•  In 1981, the energy market experienced a significant downturn and Penn Square Bank became insolvent. At this point, Continental held approximately $1 billion of Penn Square-linked loans, which led to large losses. 
• Compounding this issue was Continental’s business model that relied upon borrowing short-term money from the Federal Reserve and selling certificates of deposit (CDs).
• These funding sources proved to be insufficient to meet Continental’s growing liquidity needs, so it resorted to the high-rate lending environment in foreign (e.g., Japanese) money markets.
• Awareness of Continental’s funding challenges reached the foreign markets in May 1984. At this point, the bank became unable to borrow even at these higher rates, and depositors withdrew about 20% of the bank’s demand deposits over the span of just 10 days.
• Some have said that it was Continental Illinois that first necessitated the use of the term “too big to fail.” 

Northern Rock  

• Northern Rock was a fast-growing mortgage-focused bank in the United Kingdom. For many years leading up to the financial crisis of 2007-2009, Northern Rock had been growing assets (i.e., loans) at 20% per year. 
• Its business model was a little unusual in the British market because it deployed an originate-to-distribute (OTD) model (i.e., source loans with the goal of repackaging and selling them). 
• Its source of funding for these ventures was money borrowed in the short-term markets. The rising default rates in early 2007 eventually rippled through the global market for securitized mortgages. 
• Ironically, just before the trouble began, British regulators provided Northern Rock with a Basel II waiver, which allowed it to pay increased dividends to shareholders
• When news of this support leaked to the public, anyone who had demand deposits with Northern Rock quickly rushed in to withdraw what they could. At the time, British law only guaranteed deposits up to £2,000 with an additional 90% guarantee up to £33,000. 
• British regulators told the public that it would guarantee 100% of all deposits at Northern Rock and the run on the bank slowly subsided, but the bank had to turn itself over to public ownership in the process.

Lessons Learned

• In the wake of the financial crisis of 2007 to 2009, the Federal Reserve began to require periodic stress testing for all large U.S.-based banks. 
• This process pushed banks to consider liquidity risk mitigation in the form of either asset/liability management (ALM) or the use of derivatives, such as interest rate swaps. 
• it may not be possible for banks to exactly coordinate the durations of their liabilities and assets. This creates the need for emergency liquidity access. This could take the form of credit lines with designated lenders. Pursuing this option could be costly if the credit lines are not needed and fees are paid regardless.

Hedging Strategies

• Devising an effective hedging strategy is a challenging and potentially rewarding undertaking. It requires access to relevant data, access to appropriate statistical tools, and the right model for the analysis task at hand. 
• Once a firm decides that it wants to hedge a known risk, it needs to decide if it wants to deploy a static or a dynamic strategy. 
• A static hedging strategy involves buying a hedging instrument that closely matches the position to be hedged.  focus is on the results at the strategy’s horizon (i.e., maturity). This option requires relatively low supervision and incurs relative low transaction costs. These benefits come with the drawback of not adjusting the hedge for changes in the underlying exposure.
• A dynamic hedging strategy deploys a hedging instrument and then rebalances the hedged position on a frequent basis (e.g., daily, monthly, quarterly).
• Incumbent on a dynamic hedge is the concept of periodically updating the hedging exposures. This can be thought of as a rolling hedge

Metallgesellschaft Refining and Marketing (MGRM)

• In 1993, it implemented a marketing strategy designed to insulate customers from price volatility in the petroleum markets, for a fee.
• MGRM offered customers contracts to buy fixed amounts of heating oil and gasoline at a fixed price over a 5- or 10-year period. The fixed price was set at a $3 to $5 per barrel premium over the average futures price of contracts expiring over the next 12 months.
• hedging instruments were rolled forward each month as it expired.
• it can be profitable when assets for immediate delivery is priced higher than the futures price- backwardation scenario
• MGRM was exposed to curve risk - risk of shift in price curve from backwardation to contango and basis risk (deviations from short term prices and long term prices)
• Customers were given the option to exit the contract if the spot price rose above the fixed price in the contract, in which case MGRM would pay the customer half the difference between the futures price and the contract price
• This process left MGRM exposed to the risk of rising energy prices. The customer contracts effectively gave the company a short position in long-term forward contracts
• MGRM hedged this exposure with long positions in short-term futures using a stack-and-roll hedging strategy
• In late 1993, spot oil prices declined sharply. The result of this contango was a $1.3 billion margin call to offset unrealized losses.
• parent company directed the MGRM to close out all hedging positions. This move essentially turned an unrealized loss into a realized one.
• The fundamental issue for MGRM was a cash flow problem that constrained the company’s ability to ride out the hedge.