1.4 Financial Disasters

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1.4 Financial Disasters

Question 1

PE2018Q19 / PE2019Q19 / PE2020Q19 / PE2021Q19
The collapse of Long Term Capital Management (LTCM) is a classic risk management case study. Which of the following statements about risk management at LTCM is correct?

A. LTCM had no active risk reporting.
B. At LTCM, stress testing became a risk management department exercise that had little influence on the firm’s strategy.
C. LTCM’s use of high leverage is evidence of poor risk management.
D. LTCM failed to account properly for the illiquidity of its largest positions in its risk calculations.

Answer: D
Learning Objective: Analyze the key factors that led to and derive the lessons learned from the following risk management case studies: Model risk, including the Niederhoffer case, Long Term Capital Management, and the London Whale case.

A major contributing factor to the collapse of LTCM is that it did not account properly for the illiquidity of its largest positions in its risk calculations.

LTCM received valuation reports from dealers who only knew a small portion of LTCM’s total position in particular securities, therefore understating LTCM’s true liquidity risk. When the markets became unsettled due to the Russian debt crisis in August 1998 and a separate firm decided to liquidate large positions which were similar to many at LTCM, the illiquidity of LTCM’s positions forced it into a situation where it was reluctant to sell and create an even more dramatic adverse market impact even as its equity was rapidly deteriorating. To avert a full collapse, LTCM’s creditors finally stepped in to provide $3.65 billion in additional liquidity to allow LTCM to continue holding its positions through the turbulent market conditions in the fall of 1998, However, as a result, investors and managers in LTCM other than the creditors themselves lost almost all their investment in the fund.

Question 2

Which of the following are examples of model risk illustrated in the Long-Term Capital Management case?

I. Poor management oversight.
II. Financial reporting standards.
III. Ignoring autocorrelation of economic shocks.
IV. Underestimating correlations among asset classes during economic crises.

A. II, III, and IV only
B. Ill and IV only
C. I, II, Ili, and iV
D. I only

Answer: B
LTCM’s models underestimated the extent to which securities prices would move together in times of economic crisis.

The models also failed to anticipate that multiple economic shocks might occur in clusters through time (i.e., be positively auto-correlated) as economic history suggests.

Poor management oversight and financial reporting standards are not issues in the LTCM case.

Question 3

Which of the following is a common attribute of the collapse at both Metallgesellschaft and Long-Term Capital Management (LTCM)?

A. Cash flow problems caused by large mark to market losses.
B. High leverage.
C. Fraud.
D. There are no similarities between the causes of the collapse at Metallgesellschaft and LTCM.

Answer: A
Metallgesellschaft and Long Term Capital Management (LTCM) dealt in the derivatives market in huge quantities and both experienced a cash flow crisis due to the change in economic conditions. This led to huge mark-to-market losses and margin calls.

Question 4

In late 1993, Metallgesellschaft reported losses of approximately USD 1.5 billion in connection with the implementation of a hedging strategy in the oil futures market. In 1992, the company had begun a new strategy to sell petroleum to independent retailers, on a monthly basis, at fixed prices above the prevailing market price for periods of up to 5 and even 10 years. At the same time, Metallgesellschaft implemented a hedging strategy using a large number of short-term derivative contracts such as swaps and futures on crude oil, heating oil, and gasoline on several exchanges and markets. Its approach was to buy on the derivatives market exposure to one barrel of oil for each barrel it had committed to deliver. Because of its choice of a hedge ratio, the company suffered significant losses with its hedging strategy when oil market conditions abruptly changed to:

A. Contango, which occurs when the futures price is above the spot price.
B. Contango, which occurs when the futures price is below the spot price.
C. Normal backwardation, which occurs when the futures price is above the spot price.
D. Normal backwardation, which occurs when the futures price is below the spot price.

Answer: A
Oil prices fell in the fall of 1993 because of OPEC’s problems adhering to its production quotas, so the market changed into one of contango, so C and D are incorrect. In contango, the futures price is above the spot price and as a result Metallgesellchaft incurred losses on its short-dated long futures contracts, so B is incorrect and A is correct.

Question 5

Metallgesellschaft Refining and Marketing offered customers long-term contracts with fixed prices for petroleum contracts. Their strategy to hedge this exposure:

A. Did not account for funding risk created by a mismatch between the timing of the hedge cash flows and the contract cash flows.
B. Failed because of improper internal controls.
C. Was based on fraudulent reporting.
D. Suffered from poor diversification.

Answer: A
Metallgesellschaft implemented a stack-and-roll hedge strategy, which uses short-term futures contracts to hedge long-term risk exposure. The stack-and-roll hedge strategy proved ineffective due to interim funding cash outflows created by margin calls, a shift in the market from backwardation to contango, and other factors. No offsetting interim cash inflows were available on their long-term customer contracts, creating a liquidity crisis that was exacerbated by their size of their futures positions in relation to the liquidity of the market.

Question 6

All of the following are reasons that Nick Lesson engaged in aggressive speculative trading in the Barings Bank collapse except:

A. He was attempting to recover previous trading losses.
B. Barings’ lack of risk management oversight.
C. Barings’ risk management models were flawed.
D. His authority over settlement operations allowed him to hide trading losses.

Answer: C
The collapse of Barings Bank was not an instance of flawed hedging models, but one of poor operational control. Lesson had previously incurred huge trading losses that, if revealed, would have cost him his job. In an effort to recover those losses, he abandoned his hedging strategies and speculated to recoup these losses. His influence and authority in back office operations allowed him to hide his speculative losses and report phantom profits. Lesson ignored and exceeded risk control limits, and senior management’s lack of understanding about Leeson’s role and oversight allowed his schemes to go undetected.

Question 7

PE2018Q63 / PE2019Q63 / PE2020Q63 / PE2021Q63 / PE2022Q63
Barings was forced to declare bankruptcy after reporting over USD $1$ billion in unauthorized trading losses by a single trader, Nick Leeson. Which of the following statements concerning the collapse of Barings is correct?

A. Leeson avoided reporting the unauthorized trades by convincing the head of his back office that they did not need to be reported.
B. Management failed to investigate high levels of reported profits even though they were associated with a low-risk trading strategy.
C. Leeson traded primarily in OTC foreign currency swaps which allowed Barings to delay cash payments on losing trades until the first payment was due.
D. The loss at Barings was detected when several customers complained of losses on trades that were booked to their accounts.

Answer: B
Learning Objective: Analyze the key factors that led to and derive the lessons learned from the following risk management case studies: Rogue trading and misleading reporting, including the Barings case.

Leeson was supposed to be running a low-risk, limited return arbitrage business out of his Singapore office, but in actuality he was investing in large speculative positions in Japanese stocks and interest rate futures and options. When Leeson fraudulently declared very substantial reported profits on his positions, management did not investigate the stream of large profits even thought it was supposed to be associated with a low-risk strategy.

Question 8

Studying previous financial disasters provides lessons learned that can help improve processes and controls in order to help prevent future disasters. Which of the following case studies correctly identifies a lesson learned from the given financial disaster?

A. The Metallgesellschaft case shows the necessity of procedures that may lead to the detection of fictitious trade entries.
B. The Northern Rock case highlights the importance of correctly measuring the correlation between large positions.
C. The Barings Bank case demonstrates why firms should restrict the use of leverage in trading Derivatives.
D. The Long-Term Capital Management case shows the importance of taking into account that correlations can increase sharply during crises.

Question 9

A treasury risk manager working for a large bank is responsible for liquidity risk management. The manager is particularly interested in processes for funding liquidity risk management. Which of the following is the most appropriate process used for funding liquidity risk management?

A. Building VaR models
B. Purchasing credit default swaps
C. Implementing asset-liability management
D. Calculating loss given default

Answer: C
C is correct. Asset/liability management is a process used in managing banks’ funding liquidity risk, with techniques including gap and duration analysis. This is important because maturity mismatches on banks’ balance sheets (for example, if a bank funds longer-term loans using short-term deposits) can create risk for a bank if short-term interest rates rise faster than longer term rates.

A is incorrect. VaR models are used to manage market risk.

B is incorrect. Credit default swaps are used to hedge against counterparty risk, which is a form of credit risk.

D is incorrect. Calculating loss given default is used to quantify credit risk.

Question 10

A risk consultant is preparing a presentation to a group of junior risk managers on the lessons learned from historical financial disasters and failures of risk management at large financial firms. Which of the following correctly describes a lesson learned from the given financial disaster case?

A. The Orange County case emphasizes the importance of fully understanding complex derivative contracts before entering into them.
B. The London Whale case emphasizes the importance of considering the fact that correlations can increase sharply during a global financial crisis.
C. The Northern Rock case emphasizes the importance of having a strong cybersecurity framework.
D. The LTCM case emphasizes the importance of meeting regulatory capital requirements.

Answer: A
A is correct. Orange County imploded when Robert Citron made a large bet on inverse floating swaps, which was not fully understood by the county’s board of directors, and blew up when interest rates rose. Citron later admitted that he did not understand either the position that he took or the risk exposure of the fund.

B is incorrect. Poor correlation modeling was more a central theme of the subprime crisis or Long Term Capital Management (although the LTCM incident did not occur during a crisis.) The London Whale case took place in 2012, well after the end of the crisis, and its main themes were poor corporate governance with respect to risk concentration limits, position limits and VaR models.

C is incorrect. This refers to the SWIFT case. The Northern Rock case was a run on the bank which occurred partly due to an over-reliance on repurchase agreements and liquidity risk when repo financing dried up.

D is incorrect. The LTCM case was a case of incorrect correlation modeling and inadequate stress testing. As a hedge fund, LTCM was not covered by regulatory capital requirements at the time.

Question 11

A risk manager is analyzing several portfolios, all with the same current market value. Which of the following portfolios would likely have the highest potential level of unexpected loss during a sharp broad-based downturn in financial markets?

A. A portfolio of US Treasury notes with 2 to 5 years to maturity.
B. A portfolio of long stock positions in an international large cap stock index combined with long put options on the same index.
C. A portfolio of mezzanine tranche MBS structured by a large regional bank.
D. A short position in futures for industrial commodities such as copper and steel.

Answer: C
The portfolio of mortgage backed securities would have the highest unexpected loss since the securities should have the highest correlation (covariance) and should have the most risk of moving downward simultaneously in a crisis situation.

Question 12

PE2020Q24 / PE2021Q24 / PE2022Q24
A risk consultant is preparing a presentation to a group of junior risk managers on the lessons learned from historical financial disasters and failures of risk management at large financial firms. Which of the following correctly describes a lesson learned from the given financial disaster case?

Answer: A
Learning Objective: Analyze the key factors that led to and derive the lessons learned from case studies involving the following risk factors:

Funding liquidity risk, including Lehman Brothers, Continental Illinois, and Northern Rock
Model risk, including the Niederhoffer case, Long Term Capital Management, and the London Whale case
Financial engineering and complex derivatives, including Bankers Trust, the Orange County case, and Sachsen Landesbank

A is correct. Orange County imploded when Robert Citron made a large bet on inverse floating swaps, which was not fully understood by the county’s board of directors, and blew up when interest rates rose. Citron later admitted that he did not understand either the position that he took or the risk exposure of the fund.

C is incorrect. This refers to the SWIFT case. The Northern Rock case was a run on the bank which occurred partly due to an overreliance on repurchase agreements and liquidity risk when repo financing dried up.

D is incorrect. The LTCM case was a case of incorrect correlation modeling and inadequate stress testing. As a hedge fund, LTCM was not covered by regulatory capital requirements at the time.

Question 13

PE2022PS22
A junior risk analyst is asked to summarize the developments leading up to the financial crisis of 2007 -2009. As part of the summary, the analyst researches the role of subprime mortgages as a contributing factor to the crisis. Which of the following correctly describes a role or impact of these mortgages in the years leading up to the crisis?

A. Strict documentation requirements for new borrowers resulted in a liquidity crisis for real estate due to a lack of qualified borrowers.
B. Initial loan-to-value ratios steadily decreased for new subprime borrowers in the years leading up to the crisis.
C. Most mortgage brokers were compensated based on the performance of subprime mortgages they originated, and were forced to pay back large commissions as loans began to fail.
D. Interest rates rose sharply on many subprime mortgages after a short initial low-rate period, forcing some borrowers to default.

Answer: D
Learning Objective: Explain the role of subprime mortgages and collateralized debt obligations (CDOs) in the crisis.

D is correct. Many subprime mortgages were organized as adjustable-rate mortgages, with a very low initial “teaser” rate jumping up dramatically after two or three years. Borrowers found it easy to get these loans even with no income or job documentation, and were okay as long as they could refinance the loan or sell the property within the initial period. But as the real estate market started to weaken, more borrowers held their mortgages past the end of the initial period, and many were no longer able to afford to maintain the mortgage after the huge jump in payments.

A is incorrect. One characteristic of subprime mortgages of the time is that they were relatively easy to obtain even without proper documentation - “NINJA” (no income, no job, no assets) loans were even common.

B is incorrect. Loan-to-value ratios steadily increased both as down payment requirements were relaxed (43% of first-time home buyers paid zero down) and real estate prices eventually fell.

C is incorrect. Mortgage brokers were typically compensated on the volume of loans and not their performance, so there were very few consequences to the brokers when loans failed.

Question 14

PE2022Q19
A junior analyst has just started working for a national banking supervisor and is training for a position as a bank examiner. As part of the training program, the analyst is asked to explain how banking regulations evolved as a result of the 2007-2009 financial crisis to encourage better risk governance. Which of the following correctly describes an impact of regulations that were introduced as a result of the crisis?

A. Banks were required to securitize all the mortgages they originate in order to distribute risk across financial institutions.
B. Banks were encouraged to establish an independent risk management function with access to the board of directors.
C. Proprietary trading operations were merged with traditional banking operations to provide banks better governance over their trading desks.
D. Derivatives were encouraged to be traded OTC rather than centrally cleared to provide greater transparency.

Answer: B
Learning Objective: Explain changes in regulations and corporate risk governance that occurred as a result of the 2007-2009 financial crisis.

B is correct. One of the key governance recommendations is that banks should establish an independent risk management function with access to the board of directors. This prevents the risk function from being suppressed, as it would be if it was subordinate to other divisions such as trading operations, and ensures that the board is advised of risk issues.

A is incorrect. Securitization was a key contributor to the crisis, as many tranches of securitized mortgages had very high credit ratings but collapsed during the crisis as investors and rating agencies underestimated the potential for all the mortgages in a securitization to go down together. Post-crisis governance did not encourage increased
securitization.

C is incorrect. Dodd-Frank’s Volcker rule, for example, prohibited banks from proprietary trading, and around the world many trading operations were required to be (or were voluntarily) divested from banking operations.

D is incorrect. Post-crisis regulation encouraged central clearing when possible.