Quiz: Major Events

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6 questions to check your understanding of the chapter “Major Events”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.

1. Question 1

   How does the April 1999 report of the President's Working Group on Financial Markets describe counterparties' risk management toward Long-Term Capital Management (LTCM)?

   1. A.Exposure from future price movements was covered by collateral, but current credit risk was likely not adequately assessed
   2. B.From the balance sheets and other information LTCM supplied, the content of its risks and its concentration in particular markets were likely adequately assessed
   3. C.Credit stress tests were adequate, and counterparties did not rely on collateral arrangements alone
   4. D.Current exposure was mostly covered by collateral, but exposure from future price movements was likely not adequately assessed
   Answer and explanation

   Answer: D

   Current credit risk was in most cases covered by collateral, but the report says that the potential future exposure from future price movements was likely not adequately assessed. It also asks whether counterparties had been lulled into a false sense of security by collateral arrangements alone.

   What collateral covered was the current exposure, not the future one. Each counterparty set a credit limit, but nothing constrained LTCM's overall size and leverage. The report also says that what LTCM gave to lenders and counterparties was mainly balance sheets and income statements, which did not reveal the content of its risks or its concentration in particular markets. On stress tests, the report of the Government Accountability Office (GAO) says that examiners found that banks relied on collateral for current exposures and that their credit stress tests were insufficient.

   Learn more: The Collapse of LTCM

2. Question 2

   After Lehman Brothers Holdings Inc. (LBHI) filed for bankruptcy in September 2008, how did termination and settlement of the derivatives trades entered into under the ISDA Master Agreement proceed?

   1. A.Termination proceeded automatically, and settlement was mostly completed within 5 weeks of the filing
   2. B.Many trades were terminated in a short time, but settlement took years
   3. C.Termination did not proceed automatically, and after reconciliation and valuation counterparty by counterparty, termination alone took years
   4. D.The filing was not an event of default, and trades continued until the counterparty chose to terminate
   Answer and explanation

   Answer: B

   LBHI was the credit support provider for the obligations of Lehman group companies in almost all of these trades, so its filing was an event of default under the ISDA Master Agreement. Termination went quickly in terms of numbers: of the more than 900,000 trades, 733,000 were terminated automatically by November 13, 2008. After termination, however, trades had to be reconciled counterparty by counterparty, valued one by one, and the settlement amounts negotiated. The share of contracts that had been settled was 6% in July 2009 and 46% in September 2010.

   The 5-week figure refers to the time by which about 80% of the counterparties of Lehman Brothers Special Financing Inc. (LBSF) had terminated. Termination taking years concerned the contracts of large counterparties. What was handled outside the bankruptcy proceedings was contracts cleared through a central counterparty.

   Learn more: The Collapse of Lehman Brothers (2008)

3. Question 3

   Right after the failure of Lehman, market participants worried that sellers of credit default swaps (CDS) with reference entity Lehman would bear large losses based on the gross notional amount. What did the October 10, 2008 auction show about this worry?

   1. A.Long and short positions offset one another, and the net payment was far smaller than the gross amount
   2. B.About two-thirds of the notional amount had been written as hedges of bonds and gave rise to no payment, so the net amount was small
   3. C.The final price was 91.375 per 100 of face value, so sellers paid only 8.625% of the notional amount
   4. D.The net payment through the auction was about USD 72 billion, almost the same as the gross notional amount
   Answer and explanation

   Answer: A

   The worry was that sellers would bear losses based on the gross total of the CDS notional amount. In practice, positions offset one another, and the net amount was far smaller. According to figures from DTCC (Depository Trust & Clearing Corporation), the gross notional amount of Lehman CDS was about USD 72 billion, and the net payment through the auction was about USD 5.2 billion.

   The final price was 8.625 per 100 of face value, and sellers paid 91.375% of the notional amount. Of the Lehman CDS, about one-third could have been written as hedges of bonds, and the other two-thirds were pure derivative positions, not hedges of bonds.

   Learn more: The Collapse of Lehman Brothers (2008)

4. Question 4

   In the 2012 actions against Barclays, the final notice of the UK Financial Services Authority (FSA) and the order of the US Commodity Futures Trading Commission (CFTC) found three kinds of misconduct. Besides failures in controls, which pair of findings is correct?

   1. A.Changes to yen LIBOR submissions in collusion with people at other panel banks, and submissions lowered out of concern for reputation
   2. B.Submissions set higher than other banks' to avoid doubts about its funding, and submissions made in response to requests aimed at profits on derivatives trades
   3. C.Submissions made in response to requests aimed at profits on derivatives trades, and submissions lowered out of concern for reputation
   4. D.Changes to yen LIBOR submissions in collusion with people at other panel banks, and submissions set higher than other banks' to avoid doubts about its funding
   Answer and explanation

   Answer: C

   The FSA found that, from January 2005 to July 2008, Barclays had repeatedly made submissions that took into account requests from its interest rate derivatives traders. The CFTC's order also found that the people who made submissions complied with requests from swap traders. The other finding is that submissions were set lower than actual because of concern about negative media comment.

   Both documents state that the LIBOR definition does not allow derivatives positions to be taken into account. Changing yen LIBOR submissions in collusion with people at other panel banks is a finding made for UBS, not for Barclays. Barclays' submissions had stayed higher than other banks', but what was found was that they were set lower than actual out of concern for reputation.

   Learn more: The LIBOR Manipulation Scandal

5. Question 5

   What did the final report of the Wheatley Review in September 2012 recommend for the future of LIBOR?

   1. A.It recommended replacing LIBOR with another benchmark rate and moving administration from the British Bankers' Association (BBA) to a body run jointly by the submitting banks
   2. B.It recommended comprehensive reform rather than replacement, including moving administration to a new administrator chosen by tender
   3. C.It recommended comprehensive reform, and publishing each bank's submission after one year
   4. D.It recommended, without replacing LIBOR, using actual transaction data to support submissions and continuing to publish currencies and tenors that lack enough support
   Answer and explanation

   Answer: B

   The report concluded that LIBOR should be comprehensively reformed rather than replaced with another benchmark rate. The review judged that LIBOR was used in an enormous number of contracts, and that replacing it would carry a high risk of financial instability and large-scale litigation. The ten-point reform plan includes putting the setting and submission of the rate under statutory regulation, moving administration from the BBA to a new administrator chosen by tender, and publishing each bank's submission after three months.

   The review set out moving administration to a new administrator chosen by tender. As a weakness in how the rate was run, the review pointed to governance that relied too heavily on the submitting banks and the industry body, so moving administration to a body run jointly by the submitting banks does not fit the direction the review set out. Publishing currencies and tenors that lack enough support was to be phased out. The change of administrator took place in February 2014, when administration passed to ICE Benchmark Administration.

   Learn more: The LIBOR Manipulation Scandal

6. Question 6

   Orange County filed for protection under Chapter 9 of the federal bankruptcy code in December 1994. How did the state auditor's report of March 1995 explain the cause of the investment pool's loss?

   1. A.The pool had offset its inverse floater positions with large hedging transactions, but the hedges did not work in the year when interest rates rose sharply
   2. B.The pool put safety first, but held too many assets that were hard to turn into cash, so liquidity ran short
   3. C.The principles of investing public funds, which should rank safety, liquidity, and yield in that order, were reversed, and yield came first
   4. D.The pool used no borrowing or structured notes and held only long-maturity securities, which was the source of its vulnerability to rising rates
   Answer and explanation

   Answer: C

   The report states that the principles for investing public funds should rank safety, liquidity, and yield in that order, and concludes that the county's pool reversed this order and put yield first. The pool enlarged its assets with borrowing and held many long-maturity securities and structured notes such as inverse floaters, whose value falls when interest rates rise. As a result, when interest rates rose sharply in 1994, the value of the pool's assets fell significantly and produced a large loss.

   The state auditor's investment experts said they found no significant offsetting hedges of the inverse floater positions. The pool was run to put yield first, not safety. The experts also found that from June 1991 to June 1994, the combination of longer maturities, borrowing, and structured notes more than tripled the vulnerability of the base portfolio (the participants' original investment) to rising interest rates.

   Learn more: The Orange County Investment Pool Loss (1994)