1IntroToALM - Introduc)on to ALM Why ALM? • 

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Unformatted text preview: Introduc)on to ALM Why ALM? •  Insurance
companies
used
to
treat
assets
and
 liabili2es
separately.

 –  This
can
be
problema2c
with
products
that
are
 sensi2ve
to
interest
rates
and/or
market
returns.

 •  For
example,
variable
annui2es,
products
with
 guarantees.
 •  There
have
also
been
huge
failures
by
banks
 (Barings,
Bear
Stearns…).
 –  These
have
led
to
(evolving)
stricter
regula2ons
 w.r.t.
capital
requirements.
 Why ALM? •  ALM
tries
to
address
financial
risks
in
an
 integrated
manner.

 •  In
par2cular,
it
is
concerned
with:

 –  Market
Risk
 –  Credit
Risk
 –  Opera2onal
Risk
 –  Underwri2ng
Risk
(Insurance
companies)
 •  We
will
mainly
focus
on
the
first
two.
 Market Risk •  •  •  •  •  •  •  Stock
market
price
risk
 Commodity
price
risk
 Interest
rate
risk
 Foreign
exchange
rate
risk
 Credit
risk
 Liquidity
risk
 Vola2lity
risk
 Credit Risk •  Risk
of
loss
due
to
credit
events,
the
changing
 creditworthiness
of
obligors,
counterpar2es,
and
 en22es
referenced
in
credit
deriva2ves.
 •  Default,
migra2on,
credit
spread
movements.
 •  Examples:
 

 –  Default
of
a
bond
you
hold
(obligor)
 –  Default
of
a
counterparty
to
an
over‐the‐counter
 deriva2ve
contract
(counterparty
credit
risk)
 –  Lehman
Brothers
defaults
on
its
debt,
when
you
have
 sold
insurance
against
its
default
(you
are
the
 protec2on
seller
on
a
credit
default
swap).
 Opera)onal Risk •  "Opera2onal
risk
is
defined
as
the
risk
of
loss
 resul2ng
from
inadequate
or
failed
internal
 processes,
people
and
systems,
or
from
 external
events.
This
defini2on
includes
legal
 risk,
but
excludes
strategic
and
reputa2onal
 risk"
(BIS)
 •  Also
includes
model
risk
(risk
of
using
an
 inappropriate
or
misspecified
model).
 Examples of Opera)onal Risk •  Fraud
(e.g.
Barings)
 •  IT
failures
 •  Failures
in
seUlements
of
transac2ons
 –  HerstaU
Bank
(1974)
 •  Earthquakes
(e.g.
Barings)
 •  "Rogue"
traders
(Barings,
SocGen,…)
 Underwri)ng Risk •  Risk
of
loss
due
to
a
failure
of
underwri2ng
 standards
for
insurance
products.
 –  Risk
that
premiums
will
not
future
incurred
losses.
 Examples of ALM Failures •  Nissan
Mutual
Life:
Offering
individual
 annui2es
at
5%‐5.5%,
inves2ng
assets
in
 government
bonds.
 –  Japanese
government
bond
yields
dropped
to
 record
low
levels.
 –  The
wide
gap
between
promised
return
on
 liabili2es
and
asset
return
caused
the
company
to
 go
bankrupt.
 Examples of ALM Failures •  We
will
briefly
examine
the
recent
financial
crisis,
 with
a
par2cular
emphasis
on
a
fundamental
 liquidity mismatch problem
that
affects
many
 financial
ins2tu2ons.
 •  Oben
financial
ins2tu2ons
have:

 –  Assets
that
are
rela2vely
illiquid
and
with
long
 maturi2es.
 –  Liabili2es
that
are
liquid,
with
short
maturi2es.
 •  This
mismatch
can
cause
severe
funding
 problems,
leading
to
default,
in
the
event
of
a
 liquidity
crisis.

 Example: Banks •  Consider
a
tradi2onal
commercial
bank.

 •  Assets:
Loans
(mortgages,
commercial
loans,
 etc.)
 –  Long
maturity,
illiquid.
 •  Liabili2es:
Demand
Deposits
(essen2ally
 infinitely
liquid)
 •  This
mismatch
makes
banks
suscep2ble
to
 runs
on
their
deposits
(e.g.
bank
runs
in
the
 1930’s).

 Example: Banks •  Many
steps
were
taken
to
try
to
protect
banks
 against
runs
on
their
deposits:
 –  Deposit
insurance
 –  Minimum
capital
requirements
 –  Lender
of
last
resort
(e.g.
the
Federal
Reserve
in
 the
U.S.,
Bank
of
Canada)
 –  Bailouts
(‘Greenspan
put’)
 Example: Bear Stearns •  5th
largest
investment
bank
in
the
U.S.
 •  Went
bankrupt
aber
a
funding
crisis
in
March
 2008.
 •  Ended
up
selling
itself
to
J.P.
Morgan
for
$10

per
 share.
 –  Up
from
the
original
deal
of
$2
per
share
aber
Bear
 shareholders
threatened
to
sue.
(Opening
price
on
 Friday,
March
14,
2007:
$62
per
share).
 –  Addi2onal
help
from
the
Federal
Reserve,
which
 guaranteed
$29
Billion
in
mortgage
related
assets.
 Bear Stearns’ Stock Price Bear Stearns •  Bear
Stearns
is
an
investment
bank,
makes
its
 money
mainly
from:
 –  Proprietary
trading
ac2vi2es
(heavily
invested
in
 mortgage
assets).

 •  Primarily
funded
by
short‐term
borrowing
(i.e.
repo
market)
 •  Highly
leveraged
(leverage
ra2o
of
around
30).
 –  Services
to
corporate
clients
(investment
advising
 services,
financial
underwri2ng
services)
 –  Prime
brokerage
fees
(holding
securi2es
and
 implemen2ng
trades
for
hedge
funds).
 Bear Stearns •  Note
again
the
mismatch
between

 •  Long
Term,
Illiquid
assets:

 –  Investment
porlolios
consis2ng
of
over‐the‐ counter
deriva2ves
(e.g.
mortgage
porlolio)
 –  Physical
assets
(e.g.
building)
 •  Short
Term,
Liquid
Liabili2es:

 –  Prime
brokerage
accounts
 –  Short
term
funding
financing
trading
ac2vi2es.
 Bear
Stearns:
Timeline
 •  2006:
Housing
bubble
begins
to
deflate.
 •  Summer
2007:
Trouble
with
two
hedge
funds
inves2ng
 in
mortgage
backed
securi2es
and
run
by
Bear
Stearns
 Asset
Management.
 –  Bear
pledges
3.2
billion
to
support
the
funds
(they
s2ll
fail).
 –  Federal
reserve
begins
to
monitor
Bear’s
financial
posi2on
 •  Fall
2007:
Bear
begins
to
lobby
for
the
Fed
to
act
as
 lender
of
last
resort
to
investment
banks
(as
well
as
 commercial
banks).
 Bear Stearns Timeline •  December
20,
2007:
Company
announces
 expected
4th
quarter
loss
(mainly
due
to
write‐ downs
on
mortgage
assets).
 •  Ironically,
the
company
was
due
to
announce
 a
1st
quarter
profit
(approximately
$1/share)
 on
the
week
of
March
17,
2008.
 –  It
never
made
it
that
far.
 Bear Stearns Timeline •  During
the
week
of
March
10‐14,
2008,
Bear
Stearns
 experienced
what
was
essen2ally
a
run
on
an
investment
 bank:
 –  Market
loss
of
confidence
in
the
firm’s
ability
to
meet
short
 term
liabili2es
(repo
borrowing).

 •  Higher
interest
on
debt,
trouble
finding
lenders
(e.g.
1‐year
CDS
 spread
goes
up
to
8%
from
5.5%,
source:
WSJ).
 –  Stock
price
drops.
 –  Nervous
hedge
funds
pull
out
of
prime
brokerage
arrangements
 (find
other
investment
banks).
 –  More
loss
of
confidence
in
firm’s
ability
to
meet
short
term
 liabili2es.
 •  Etc.
(Cycle
repeats
itself
un2l
firm
busts
–
for
example
when
it
can’tre‐ finance
the
short
term
liabili2es
that
support
the
trading
ac2vi2es).


 Bear Stearns: Speed of the Collapse •  Began
week
of
March
10
with
18.1
Billion
in
cash.
 •  By
Thursday
evening,
it
had
only
about
$3
Billion.
 –  Most
of
the
money
that
went
out
(13.9
Billion)
was
 due
to
loss
of
prime
brokerage
clients.
 –  Other
significant
cash
sinks
were
fixed
income
loans
 (2.5
Billion),
Commercial
paper
(900
million).
 –  Leb
Bear
with
insufficient
cash
to
refinance.
 •  Book
value
of
shares
~
$80.
 •  Source:
“Street
Fighters”,
by
Kate
Kelly
 Treasury‐Eurodollar Spread (TED Spread) Source:
Wikipedia
 Source:
Wikipedia
 Other
Examples
 •  Structured
Investment
Vehicles
and
Asset
 Backed
Commercial
Paper
 Fees,
Equity
 Bank
 Guarantees
 SIV
 (holds
risky
 assets
(e.g.
 CDOs)
 Bonds
 ABCP
 Capital
Markets
 $ SIVs
and
ABCP
 •  Investors
lost
trust
in
opaque
SIVs
with
illiquid,
 risky
assets.
 •  SIV
can’t
renew
its
short‐term
ABCP
funding.
 •  Sponsoring
financial
ins2tu2on
suffers
losses
 through
the
guarantees.
 Money
Market
Funds
 •  Aber
Bear,
Lehman
Brothers
(bankruptcy
filing
on
 Sept.
12,
2008),
Merrill
Lynch
(sold
itself)
to
Bank
 of
America.

 •  Money
market
funds
are
meant
to
be
‘super‐safe’,
 very
liquid.
 •  One
of
the
oldest
funds,
Reserve
Primary
Fund,
 had
invested
heavily
in
Lehman
short
term
debt.
 –  ‘Broke
the
buck’
(went
below
par)
in
Sept,
2008,
 triggering
a
run
on
money
market
funds.
 Money
Market
Funds
 •  Some
funds
had
tried
to
offer
higher
returns
 by
inves2ng
a
small
por2on
of
assets
in
illiquid
 securi2es.
 –  Investors
lost
faith
as
they
did
not
know
what
the
 funds
held,
and
who
would
be
next.
 –  Run
on
money
market
funds.
 –  Federal
Reserve
and
Treasury
had
to
step
in
to
 provide
liquidity
and
insurance.
 Hedge
Funds
 •  Short‐term
financing
by
investors
(usually
can
pull
out
 funds
aber
a
short
lock‐out
period).
 •  Oben
have
highly
leveraged
investments
in
highly
 illiquid
over‐the‐counter
assets.
 •  If
funds
perform
poorly,
investors
can
pull
out
their
 money.
 –  Distressed,
illiquid
assets
can
only
be
sold
at
‘firesale
 prices’
 –  Posi2ons
so
big
that
aUempted
sales
affect
price.
 –  Collateral
calls
forcing
more
losses,
further
sales.
 –  Downward
spiral.
 –  Addi2onal
financing
from
the
repo
market.
 Spread
of
the
Crisis
 •  More
tradi2onal
banks
(see
LIBOR
graph)
 •  Corporate
sector:

 –  Commercial
paper
used
for
short
term
financing
 by
many
corporate
treasurers.
 –  Main
investor
is
money market funds.
 –  Downfall
of
money
market
funds
makes
it
difficult
 to
meet
working
capital
requirements.
 –  Federal
Reserve
had
to
create
a
facility
to
 purchase
corporate
commercial
paper.
 Common
Threads
in
the
Examples
 •  Long
term,
illiquid
assets
(oben
opaque
to
 investors
and/or
counterpar2es).
 •  Liquid,
short
term
liabili2es.
 •  High
leverage.
 References
 •  Kelly,
K.,
“Street
Fighters”,
Porlolio,
2009.
 •  Acharya,
V.,
Philippon,
T.,
Richardson,
M.,
and
 Roubini,
N.,
“The
Financial
Crisis
of
 2007‐2009:
Causes
and
Remedies”,
in
 Restoring
Financial
Stability:
How
to
Repair
a
 Failed
System,
Acharya,
V.
and
Richardson,
M.,
 editors,
Wiley,
2009.
 ...
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This note was uploaded on 10/30/2009 for the course ACTSC 331 taught by Professor David during the Spring '09 term at Waterloo.

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