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P1.T1.20.14. Learning from financial disasters (first of three)

Nicole Seaman

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Learning objectives: Analyze the key factors that led to and derive the lessons learned from case studies involving the following risk factors: Interest rate risk, including the 1980s savings and loan crisis in the US; Funding liquidity risk, including Lehman Brothers, Continental Illinois, and Northern Rock; and Implementing hedging strategies, including the Metallgesellschaft case

Questions:

20.14.1. Arguably the U.S. savings and loan (S&L) crisis in the 1980s had multiple causes, but among the following which is the BEST summary explanation of the S&L crisis?

a. S&Ls engaged in a practice called "riding the yield curve" but this was one of the central bank's monetary policy tools and was not meant to be performed by private banks
b. The Fed's restrictive monetary policy led to a dramatic increase in short-term interest rates which wiped out bank's interest rate spread due to their asset-liability mismatch
c. The Fed's expansionary monetary policy led to a dramatic decrease in short-term interest rates which wiped out bank's interest rate spread due to their asset-liability mismatch
d. New regulations introduced in the early 1980s hindered the ability of the savings and loan (S&L) industry to lend and/offer new loan products that could help it grow out of its problems


20.14.2. Three famous financial disasters are Continental Illinois (whose failure in 1984 was the largest bank failure in US history prior the global financial crisis), Lehman Brothers (who was the fourth-largest U.S. investment bank before filing for bankruptcy in 2008), and Northern Rock (who was a fast-growing British mortgage bank, who in 2008 was forced into public ownership as an alternative to insolvency). What did Continental Illinois, Lehman Brothers, and Northern Rock have in common?

a. Excessive reliance on certain short-term liabilities
b. Insufficient geographical diversification of funding sources
c. Asset-to-equity ratios were too low for banks to be profitable
d. Improper application of Federal Reserve stress testing programs


20.14.3. Metallgesellschaft (MGRM) was the U.S. subsidiary of a German industrial conglomerate who suffered a $1.3 billion loss in 1993. MGRM had famously hedged long-term, fixed-price contracts to deliver oil to its customers with futures contracts. Which of the following BEST explains the flaw(s) in its hedging strategy?

a. Margin calls due to a drop in oil prices plus rollover losses due to a shift in the forward curve from backwardation to contango
b. Margin calls due to an increase in oil prices plus rollover losses due to a shift in the forward curve from contango to backwardation
c. Booked (paper) losses on long-term forward contracts could not be offset by the hedging gains on short-term futures contracts
d. The fixed-price contracts sold to end-user customers deserved a dynamic hedging strategy but MGRM implemented a deadly static hedging strategy

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