ABOUT THE AUTHOR

Donald R. Van Deventer, Ph.d.

Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura.

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Case Studies in Liquidity Risk: State Street

07/20/2011 09:45 AM

Today’s blog focuses on the U.S. dollar funding shortfall that took place at State Street during the period from February 8, 2008 to March 16, 2009. Today’s blog shows that much of State Street’s funding needs came from an unexpected source: losses in the firm’s investment management business, which normally would be borne by the investors in the funds managed by State Street.  We reach a conclusion that we have reached often in this liquidity risk series: State Street borrowed nearly three times more money from the Federal Reserve than Lehman Brothers was refused until after its bankruptcy was announced September 14, 2008.

This is the fifteenth Kamakura case study in liquidity risk, following earlier blogs on AIG, Bank of America, Countrywide Financial, Merrill Lynch, a consolidation of the latter three firms, Lehman Brothers, Morgan Stanley, Citigroup, Dexia SA, Depfa Bank plc, Barclays, Goldman Sachs, the combined JPMorgan Chase, Washington Mutual, and Bear Stearns, and Wachovia.

Under the Dodd-Frank Act of 2010, the Board of Governors of the Federal Reserve was required to disclose the identities and relevant amounts for borrowers under various credit facilities during the 2007-2010 financial crisis.  These credit facilities provide perhaps the best source of data about liquidity risk and funding shortfalls of the last century.  This data is available for purchase from Kamakura Corporation and is taken from the Kamakura Risk Information Services Credit Crisis Liquidity Risk data base. We use this data to determine to what extent there was a funding shortfall at State Street during the credit crisis.

The data used for State Street in this analysis are described in more detail below. The data consist of every transaction reported by the Federal Reserve as constituting a “primary, secondary, or other extension of credit” by the Fed. Included in this definition are normal borrowings from the Fed, the primary dealer credit facility, and the asset backed commercial paper program. Capital injections under the Troubled Asset Relief Program and purchases of commercial paper under the Commercial Paper Funding Facility are not included in this definition put forth by the Federal Reserve.

A detailed chronology of the 2007-2009 credit crisis is given in these two recent blog posts:

van Deventer, Donald R. “A Credit Crisis Chronology Part 1 Through February 2008: This Time Isn’t Different,” Kamakura blog, www.kamakuraco.com, May 13, 2011.

van Deventer, Donald R. “A Credit Crisis Chronology Part 2 March 2008 Through March 2009: This Time Isn’t Different,” Kamakura blog, www.kamakuraco.com, May 14, 2011.

The key dates in the chronology relevant to State Street are summarized below. The Levin report referred to below is the report entitled “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse,” Majority and Minority Staff Report, Permanent Committee on Investigations (Senator Carl Levin, Chairman), U.S. Senate, April 13, 2011. The SIGTARP report means the document entitled “Emergency Capital Injections Provided to Support the Viability of Bank of America, Other Major Banks, and the U.S. Financial System,” Office of the Special Inspector General for the Troubled Asset Relief Program, October 5, 2009.

November 1, 2007
State Street facing three lawsuits over bond fund losses (Source: USAToday)
January 3, 2008
State Street ousts head of State Street Global Advisors after losses (Source: Bloomberg).
January 4, 2008
State Street announces settlement of $618 million on lawsuit tied to losses in pension funds managed by State Street due to declines in prices on mortgage-backed securities (Source: New York Times).
April 10, 2008
State Street hires new chief risk officer after derivatives index losses (Source: Seeking Alpha).
October 15, 2008
State Street may set aside as much as $450 million in losses from propping up fixed income funds (Source: Bloomberg).
December 4, 2008
State Street announces plans to lay off 1800 staff (Source: Finextra.com)
January 20, 2009
State Street stock plunges 59% when firm announces fourth quarter earnings and unrealized fixed income losses of $6.3 billion. State Street also revealed it had spent $3 billion more to prop up stable value funds. (Source: Bloomberg).
January 21, 2009
State Street downgraded by Standard & Poor’s to A+ from AA- (Source: Standard & Poor’s).

This blog reports on “primary, secondary, or other extensions of credit” by the Federal Reserve to State Street during the period February 8, 2008 to March 16, 2009. State Street’s borrowings from the Federal Reserve can be summarized as follows:

Borrowing dates:
First borrowing February 20, 2008 for $605,000,000,
with intermittent borrowings thereafter, followed by a
$3.3 billion borrowing on September 22, 2008.
Borrowings were continually outstanding thereafter
until the end of the Fed data series on March 16, 2009.
Average from
2/8/2008 to 3/16/2009
$9.0 billion
Average when Drawn
$19.8 billion
Maximum Drawn
$77.8 billion on October 1, 2008
Number of Days with
Outstanding Borrowings
183 days

The graph below shows the one month and one year default probabilities for the State Street from Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form credit model. Default probabilities began rising sharply after the January 20, 2009 earnings announcement that revealed $9 billion of previously undisclosed losses:

Cumulative default risk is shown below for State Street on January 27, 2009, the peak level reached during the credit crisis. State Street’s 5 year cumulative default risk was 3.47% and its 10 year cumulative default risk was 5.12%.

The graph below shows the dramatic spike in borrowings that began on September 22, 2008 and peaked at $77.8 billion on October 1, 2008. State Street received $2 billion in capital under the Capital Purchase Program of the Troubled Asset Relief Program on October 28, 2008 according to the SIGTARP Report.  Most important, State Street’s dramatic need for funds in the wake of the failures of Lehman, Washington Mutual, Wachovia, FNMA, and FHLMC should be remembered by every serious analyst of liquidity risk at large financial institutions.

In the chart below, we compare State Street’s consolidated funding short fall to those firms whose liquidity risk we have previously analyzed in this series.  State Street’s consolidated funding shortfall, measured by average drawn borrowing of $19.8 billion, ranks fifth among the firms analyzed in this series to date.

If one ranks the same firms by largest outstanding borrowing on a single day, State Street ranks third, with a peak borrowing of $77.8 billion, almost $50 billion more than the $28 billion post-bankruptcy borrowing of Lehman Brothers:

Borrowings During the Bear Stearns Crisis, March 14, 2008 to May 31, 2008

If we focus on the period from March 15 (one day prior to the JPMorgan Chase absorption of Bear Stearns) to May 31, 2008, State Street was relatively unaffected. The bank ranks 25th in average borrowings.

If one analyzes the maximum borrowings during the Bear Stearns crisis, March 15-May 31, 2008, State Street ranks 28th:

Borrowings from the Commercial Paper Funding Facility

The Federal Reserve’s disclosure of borrowings under the Commercial Paper Funding Facility list 16 transactions in which State Street Bank & Trust is listed as “parent/sponsor at time of purchase.”

Implications of Funding Shortfall Data

We find once again, after reviewing State Street’s borrowings from the Federal Reserve, that State Street borrowed $50 billion more, a maximum of $77.8 billion, than the $28 billion which was refused to Lehman Brothers until that firm declared bankruptcy.  This is further confirmation that the definition of “too big to fail” was dramatically revised immediately after Lehman’s demise, since State Street’s peak borrowing was on October 1, 2008, only 17 days after Lehman’s September 14 bankruptcy announcement.

Background on the Federal Reserve Data

A summary of the Federal Reserve programs that were put into place and summary statistics are available from the Federal Reserve at this web page:

http://www.federalreserve.gov/newsevents/reform_transaction.htm

Today’s blog focuses on one set of disclosures by the Federal Reserve: primary, secondary and other extensions of credit by the Fed.  This includes direct, traditional borrowings from the Federal Reserve, the primary dealer credit facilities, and the asset backed commercial paper program described at the link above.  These borrowings do not include commercial paper purchased under the Commercial Paper Funding Facility nor do they include the equity stakes taken by the U.S. government under the Troubled Asset Relief Program.

Kamakura took the following steps to consolidate the primary, secondary and other extensions of credit:

  • From www.twitter.com/zerohedge Kamakura downloaded the daily reports, in PDF format, from the Federal Reserve on primary, secondary and other extensions of credit from February 8, 2008 until March 16, 2009, approximately 250 reports in total
  • Kamakura converted each report to spreadsheet form
  • These spreadsheets were aggregated into a single data base giving the origination date of the borrowing, the name of the borrower, the Federal Reserve District of the borrower, the nature of the borrowing (ABCP, PDCF, or normal), the maturity date of the borrowing, and (in the case of Primary Dealer Credit Facility) the name of the institution holding the collateral.
  • Consistency in naming conventions was imposed, i.e. while the Fed listed two firms as “Morgan Stanley” and “M S Co” Kamakura recognized to the maximum extent possible that they are the same institution and used a consistent name
  • To the maximum extent possible, the name of the ultimate parent was used in order to best understand the consolidated extension of credit by the Fed to that firm.

For information regarding the Kamakura Credit Crisis Liquidity Risk data base, please contact us at info@kamakuraco.com.  Please use the same e-mail address to contact the risk management experts at Kamakura regarding how to simulate realistic liquidity risk events in the Kamakura Risk Manager enterprise-wide risk management system.

Donald R. van Deventer
Kamakura Corporation
Honolulu, Hawaii
July 20, 2011

© Copyright 2011 by Donald R. van Deventer, All Rights Reserved.

 

ABOUT THE AUTHOR

Donald R. Van Deventer, Ph.d.

Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura.

Read More