May 2010

Public Lecture on the Impact of Lehman's Collapse

Dr. Chi-Fu Huang speaks on the impact of Lehman Brother's Swap and Repo Business on Fixed Income
Spread Markets.

On April 6, 2010, the NUS Risk Management Institute organized a public seminar titled "Impact of Bankruptcy of Lehman's Swaps and Repo Businesses on Fixed Income Spread Markets" by Dr. Chi-Fu Huang, former J.C. Penney Professor of Finance at the Massachusetts Institute of Technology, and Founder and Chairman of Platinum Grove Asset Management (PGAM), a multi-strategy alternative investment management company based in Rye Brook, New York.

At the outset, Dr. Huang stated that without regulators' intervention, filing bankruptcy effectively allowed all of Lehman's counterparties to terminate their over-the-counter (OTC) contracts transacted through Lehman. The collapse resulted in a massive unwinding of matched book positions - those positions for which Lehman acted only as an intermediary between two counterparties without Lehman holding a net position. He further explained that theoretically if both sides of the matched transactions are simultaneously replaced, there would be little impact on the markets as the offsetting replacement transactions are market neutral. However, Dr Huang pointed towards the observed asymmetry in the speed of replacing positions after termination with Lehman and argued that this asymmetry caused the dislocations in the swap and repo markets.

Dr. Huang noted that the market turmoil was avoidable, as there had been precedence for successful regulator intervention. The New York Federal Reserve could have minimized systemic risk by transferring Lehman's matched books to another derivatives dealer as had occurred when Dresdner Bank and Refco Inc failed.

Impact on Swap Markets

In an interest rate swap (IRS), two counterparties exchange a fixed interest rate for a floating interest rate at regular time intervals. The floating rate is usually set to be equal to a short-term benchmark rate, like the USD LIBOR rate, while the fixed rate is set when the swap is initiated and reflects the market expectation of the level of the floating rate throughout the life of the swap. By convention, an IRS "receiver" is the counterparty that receives fixed and pays floating, and the IRS "payer" is the counterparty that pays fixed and receives floating.

While the Federal Reserve did not immediately cut the target Fed Funds rate after the collapse of Lehman, cutting this rate was widely anticipated as a necessary measure to ensure liquidity in the markets. Counterparties to Lehman who were IRS receivers rushed to replace their long duration positions in the markets immediately, since such positions would likely increase in value, receiving the same fixed rate for an anticipated lower floating rate. The increase in value could then be used to hedge losses from other short duration positions in their portfolio.

However, the converse was true for counterparties who were IRS payers. Due to bankruptcy regulations, the payers had already closed their positions with Lehman at a single closing price, regardless of the contract size. Since the short duration positions that IRS payers owned were probably used to hedge their long duration exposures, and long duration exposures were likely to rise in value, there was no incentive for the IRS payers to replace their loss-making hedges immediately.

Under the Expectations Theory of interest rates, forward interest rates are what the market expects future interest rates to be. However, a few weeks after Lehman filed for bankruptcy on September 15, 2008, the long end of the term structure of the USD interest rates fell sharply. Between September 15, 2008 and October 17, 2008, the 30-year end of the two-week USD forward curve fell by about 30 basis points. While the rates at 30-years could be distorted by market expectations of future economic conditions, such as long-term inflation rates, Dr. Huang believed it was unreasonable for the markets to have such strong opinions on interest rates movement 20 to 30 years into the future that could affect 30-year forward rates so strongly. The more plausible reason for the drop in 30-year rates was the massive influx of IRS receivers looking to immediately replace their terminated Lehman swap positions, and the shortfall of IRS payers who were willing to wait to replace their loss-making swap positions. Since swaps are usually long-dated contracts, the demand and supply imbalance depressed the longer maturity end of the term structure.

To illustrate the demand and supply imbalances, Dr. Huang utilized a quantitative model to generate an estimation of the fair value for the 30 year rates based on a linear combination of interest rates at four other standard maturities.

The swap rate from the model is then compared to the 30 year USD swap rates. Since the market and model rates are supposed to track the value of each other over time, if the market rate is greater than the model rates, market participants would profit from entering an IRS as a receiver. The converse is true when the market rate is lower than the model rate.

The results implied by the quantitative model are consistent with stylized facts, with market rates above model rates during periods of distress, such as the Russian default, with government cutting interest rates to prevent recession and market rates below model rates during times of stability, like before the Dotcom crash, with governments increasing interest rates to curb inflation.

However, in contrast to previous crises, the market swap rates were below model rates in the case of Lehman's collapse. This means that interest rates were too low relative to the model predictions due to IRS receivers rushing into the market to replace their long duration positions.

The dislocation in the fixed income market was not limited to the U.S. Europe also experienced low 30-year EUR swap rates relative to the model, as defined benefits pension funds replaced their long dated receiver IRS in the market to hedge their liabilities. On the other hand, parties on the other side of the matched book, such as the economies with lower credit ratings including Greece and Italy, other banks and hedge funds postponed the issuance of new debt.

Impact on Repo Markets

In a repo, a borrower sells a security to a lender for cash and agrees to buy back the same security from the lender at a fixed price at a later date. This is essentially a collateralized loan. However, when Lehman filed for bankruptcy, all repos transacted through Lehman were terminated, and the lenders were left with the borrower's assets while the borrowers were left with cash.

If the borrower posted collateral consisting of an asset that is desirable in distress environments, they would likely try to replace the asset from the market immediately. If the asset that was posted as collateral would not perform well in a distressed environment, the borrower can choose not to replace their exposures and simply keep the cash that was borrowed. However, the lender in a repo is probably looking to generate some short-term interest and is not likely to have the expertise or an economic interest in managing the asset for the long-term. Hence, the lender will likely sell any collateral it owns from the termination of the repo to replace its cash position. As a result, the supply of all collateral assets would increase, but there would only be a flight to quality to the desirable assets. According to Dr. Huang, the above phenomena would be observable via the price of the undesirable assets falling relative to the price of the desirable asset.

During periods of distress, both interest rates and the inflation rate are likely to fall. Hence, inflation-linked bonds are likely to be undesirable assets while fixed interest bond are likely be desirable. An inflation-linked bond can be converted into a synthetic nominal bond by shorting inflation rates using inflation-linked swaps. This synthetic yield should not have a significant spread over the nominal yield of a similar nominal bond under normal circumstances.

However, when Dr. Huang charted the spread between the synthetic yield from U.K. inflation-linkers and the yield from nominal bonds, he discovered that the synthetic yield of the inflation-linkers traded at between 40 to 120 basis points above the yield of a nominal bond from the collapse of Lehman to December 5, 2008. This meant that the price of inflation-linkers fell relative to the price of nominal bonds, even after converting their real yields into synthetic yields. This observation lends credit to the hypothesis that the collapse of Lehman led to indiscriminate selling of collateral by lenders to recover their cash but only selective replacement of desirable assets by the borrowers.

Conclusion

Dr. Huang concluded by reminding the audience that although matched book operations are risk-free for derivative dealers, sudden termination of matched book positions can lead to significant market dislocations as market participants replace long duration positions ahead of short duration positions in distress scenarios. Regulators trying to lower systemic risks should also be mindful of this fact when dealing with collapsing financial entities in the future. Furthermore, assets that are normally highly correlated with very similar cash flows, such as stripped inflation-linked bonds and nominal bonds, also diverged significantly in value. This has important implications for market risk management as regulators and arbitrageurs can make the markets more allocatively efficient and less volatile by buying up the undervalued assets and making price a better signal of value.