1.9 Learning From Financial Disasters

Question 1

What is “riding the yield curve”?

Answer 1

A strategy where financial institutions borrow short-term at lower interest rates and invest in long-term assets with higher yields.

Question 2

What was the primary cause of the Savings and Loan (S and L) crisis of the 1980s?

Answer 2

Interest rate risk mismanagement.

Question 3

What triggered Lehman Brothers’ collapse in 2008?

Answer 3

High exposure to real estate-linked assets, liquidity crisis, and failed bailout attempts.

Question 4

What is a “flight to quality” in financial markets?

Answer 4

Investors shifting capital from risky assets to safe assets like U.S. Treasury securities and gold during financial crises.

Question 5

What was the main cause of Enron’s collapse?

Answer 5

Corporate governance failure, including fraudulent accounting practices.

Question 6

Why did Northern Rock experience a bank run in 2007?

Answer 6

Rumors of a Bank of England bailout caused depositor panic and mass withdrawals.

Question 7

How did LTCM’s collapse differ from Metallgesellschaft’s failure?

Answer 7

LTCM failed due to increased market correlations, while Metallgesellschaft was affected by futures price curve changes.

Question 8

What risk management failure was central to the London Whale case?

Answer 8

Repeated breaches of risk limits and misuse of risk models to understate capital requirements.

Question 9

How do safe-haven assets behave during a financial crisis?

Answer 9

Their yields decline due to increased demand, while interest rates in riskier countries rise.

Question 10

Why did liquidity risk contribute to Lehman Brothers’ downfall?

Answer 10

It relied on short-term funding but could not roll over its debt as market confidence collapsed.

Question 11

What was the main flaw in LTCM’s risk models?

Answer 11

They underestimated market correlations, assuming they would remain low.

Question 12

Why was Northern Rock exposed to liquidity risk rather than interest rate risk?

Answer 12

It funded long-term loans with short-term liabilities, creating a funding mismatch.

Question 13

How did governance failures contribute to the London Whale case?

Answer 13

Management ignored risk breaches, downplayed risk metrics, and failed to take corrective action.

Question 14

How did fraudulent activity contribute to the Barings Bank collapse?

Answer 14

Rogue trader Nick Leeson engaged in unauthorized derivatives trading, leading to massive losses.

Question 15

What is model risk in financial trading?

Answer 15

The risk of loss due to incorrect assumptions, poor calibration, or execution failures in financial models.

Question 16

How did Lehman Brothers’ counterparty risk contribute to its collapse?

Answer 16

Trading partners reduced exposure, cutting off liquidity and worsening its financial distress.

Question 17

How did Enron’s fraudulent accounting practices work?

Answer 17

It hid debt in off-balance-sheet entities to inflate earnings and mislead investors.

Question 18

What was the irony of LTCM’s collapse and bailout?

Answer 18

Banks that took over LTCM’s positions ultimately profited when markets normalized.

Question 19

How do increased market correlations amplify financial crises?

Answer 19

Previously uncorrelated assets start moving together, leading to simultaneous losses across portfolios.

Question 20

What governance failures allowed Société Générale’s Jérôme Kerviel to accumulate unauthorized positions?

Answer 20

Weak internal controls, failure to monitor trading activity, and lack of risk oversight.