The Financial Crisis of 2008

Active Balance Sheet Management and Value at Risk?

"When the music stops, in terms of liquidity, things will be complicated. But as long
as the music is playing, you've got to get up and dance. We're still dancing." –
Charles Prince, CEO, Citigroup, in an interview in London’s Financial Times, July 9th,
2007
The financial crisis beginning in July 2007 and still unfolding today, has wreaked

havoc on global financial markets. Arising from the increased delinquency rates of

subprime mortgages, total losses are estimated between US$ 400 and 500 billion.

Though these losses are undoubtedly enormous, economists have argued that when put

into a historical perspective they are not catastrophic, and in fact correspond to occasional

drops of between two and three percent in the U.S. stock market. However, the affects of

the current crisis have been much more dramatically felt, as the US stock market has

declined roughly 40% from its peak in October 2007. The tremendous amplification of

the subprime losses and systemic contraction of business activity in all sectors may be

directly attributed to the fact that commercial and investment banks ran highly leveraged

balance sheets in the years leading up to and during the subprime failure. In an attempt to

provide context for the sudden decline of financial conditions in the US, a closer

examination of the active management of the balance sheets of financial institutions may

help to identify key contributing factors that led to such a rapid deterioration.

As the subprime disaster began to unfold in the middle of 2007, market analysts

and policy makers were assured that the fallout could be minimized for two reasons. One,

financial institutions appeared to be large enough and were assumed to have enough
capital to absorb any losses, and two, securitization of subprime loans via collateralized

debt obligations (CDO’s) diluted the concentrated risk of individual loans by spreading

them out amongst various investor pools. However, the subprime mess quickly

developed into a crisis culminating in a virtual systemic meltdown in global markets that

continues to run unabated in spite of concerted global attempts to control the damage.

Clearly with the luxury of hindsight, the assumptions made in 2007 appear to be based on

a faulty logic. As well, it appears that the sub-prime securitizations and subsequent

failures that prompted this disaster were not solely confined to the US, but were

propagated across European and Asian banks, which have suffered losses as great, if not

greater than as those in the US. As can be seen in table 1, 15 of the 24 banks that have

reported major losses since the start of this crisis are based outside of the US, clearly

indicating the globalized nature of the financial network. Just how this seemingly

manageable risk became a worldwide contagion is best understood by examining the

active management of the balance sheets of financial institutions as well as the

amplification of this contagion via a globalized network effect.

Table 1. Reported Credit Losses by Major Banks January 2007- October 2008
Bank Country US$ Billions
Citigroup USA 60.8
Wachovia USA 52.7
Merrill Lynch USA 52.2
Washington Mutual USA 45.6
UBS CHE 44.2
HSBC GBR 27.4
Bank of America USA 21.2
JPMorgan Chase USA 18.8
Morgan Stanley USA 15.7
IKB Deutsche Indus DEU 14.3
Royal Bank of Scotland GBR 13.8
Lehman Brothers USA 13.8
Deutsche Bank DEU 10.1
Crédit Suisse CHE 10.1
Wells Fargo USA 10
Crécdit Agricole FRA 8.6
Barclays GBR 7.5
 Canadian Imperial (CIBC) CAN 7.1
Fortis BEL/NLD 6.9
Bayerische Landes DEU 6.7
HBOS GBR 6.6
ING Groep NLD 6.5
Société Générale FRA 6.4
Mizuho Financial Group JPN 6.1
Subtotal 473.1
Worldwide 586.2
Source: Bloomberg and Financial Times (October 1, 2008) http://www.ft.com/indepth/creditsqueeze

Financial institutions in the US utilize a mark to market accounting method,

wherein the changing value of a firm’s assets is immediately reflected on their balance

sheets. In a healthy market, this method provides improved insights into the risk profile

of firms over a historical cost-based accounting system (Sapra, 2008). However in

periods of financial crisis, mark to market accounting causes interactions between

institutions and markets where asset prices reflect the amount of liquidity available at a

specific moment rather than the calculated expected future returns from that asset (Allen

& Carletti, 2008). Thus the daily price volatility of specific assets directly and

immediately affects the asset’s value as recorded on the balance sheet. Such is the case

in the illiquid subprime mortgage market, where the market value of some firm’s assets

has fallen below their liabilities, rendering them insolvent. Many have argued that mark

to market accounting leads to large changes in the balance sheets of financial institutions

that are not justified by fundamentals. This can quickly create a downward spiral in asset

prices resulting from deficient liquidity, and has the effect of injecting a contagion that

transforms a liquidity crisis into a solvency crisis, which can be permanently devastating

(Allen & Carletti, 2008). A potential alleviation of this contagion is to allow firms to

utilize historic cost accounting in times of crisis, essentially recording their asset values

as if there was no change in value since the date of acquisition (Mackintosh, May 2,
2008). This method would permit the banks assets to mature, requiring them to record

the value at maturity, which in theory should allow them to continue to meet their

liabilities. While nether accounting method is perfect, it is worth noting the role of a

mark to market accounting system has functioned as an exacerbating factor in the current

financial crisis.

Beyond the utilization of a preferred accounting method, two critical and

dependent components of the recent financial crisis have emerged as culpable agents on

the balance sheets of financial institutions: (1) leverage, defined as the ratio of total assets

to equity, and (2) liquidity, defined as the ability to convert an asset to cash. It is well

known that financial institutions respond to price and risk changes by actively managing

their balance sheets in order to optimize the proper balance of assets to liabilities (T.

Adrian & Hyun Song Shin, 2008). A model of representing risk via the balance sheet is

known as the value at risk model (Holton, 2003). Where the actual value at risk is

calculated as a tangible numerical value to represent an estimation of the firms worst case

loss scenario or the capital it must hold in order to stay solvent. Value at risk per dollars

of assets held by a bank is denoted by V, while the total value at risk is calculated by

multiplying V by the total assets, A. A bank should maintain a capital amount, E, to equal

the total value at risk, so that E = V x A. According to the value at risk model, leverage L

is equal to the total assets A divided by the capital E to meet the value at risk, L=A/E and

since E = V x A, leverage can simply be calculated by L = 1/V. Therefore if leverage is

defined as having an inverse relationship with the value at risk, then it is true that

leverage is high when values at risk are low, which often occurs in “liquidity bubbles”

when asset prices are high and financial conditions are optimal. However in times of
 financial weakness, when asset prices are relatively lower, leverage will also be low.

According to recent research by the Federal Reserve Bank of New York, which

analyzed the assets and liabilities of banks from 1974 to 2005 a clear picture of balance

sheet management of banks emerged as the data shows that liabilities were far more

volatile than assets, as can be seen in Chart 1.

Chart 1. Asset and Liability Growth of U.S. Bank Holding Companies

Annual Growth (percent)

Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts {{350
Adrian,Tobias 2008;}}.

The report concluded that during financial boom periods banks increase their liabilities

far more than they increase their assets, and conversely, during economic downturns,

they reduce their liabilities far more than they reduce their assets (T. Adrian & Hyun

Song Shin, 2008). Book leverage which is defined as the value of a companies’ total

assets divided by the value of the companies’ total equity (equity = assets – liabilities)

thus follows a pro-cyclical pattern as banks increase leverage in booms and decrease
leverage in downturns (T. Adrian & Hyun Song Shin, 2008). The authors report that the

majority of banks will carry loans as a large proportion of the assets on their balance

sheet, which are recorded at book value. Because of this, the book value of the loans on

the balance sheet will often understate their market value during booms, and during

downturns, the book value will overstate the market value of the loans. While the

adjustment of value at risk may seem a routine task, it becomes clear that the aggregate

and immediate adjustment of leverage by several banks via balancing the value at risk

ratio can significantly amplify the financial cycle on both routine upswings and

downswings. However, in a crisis, this amplification can be even further exaggerated in

the network of interbank lending and borrowing to the point where liabilities may

become so apparently overstated beyond their book value, that a panic in the markets

ensues once these “losses” are recorded on the balance sheet.

A closer look at the active management of a firm’s balance sheet is helpful in

order to fully appreciate the consequences of leverage and the pro-cyclical movements in

financial booms and busts. An example was adapted from the literature, which detailed a

bank with a target leverage of 10. Since leverage is defined as the ratio of assets to

equity, (L = Assets/Equity) or 10 = 100/10. The bank would maintain the following

greatly simplified balance sheet, holding 100 worth of assets, funded by debt worth 90

and equity worth 10 (T. Adrian & Shin, February 2008):

Assets Liabilities

Securities, 100 Equity, 10

Debt, 90
If assets were to increase by 1% to 101, while debt remains constant:

Assets Liabilities

Securities, 101 Equity, 11

Debt, 90

Leverage which is equal to Assets/Equity falls from 100/1 = 10

to 101/11 = 9.18. Since the bank is targeting leverage of 10, it must issue enough

additional debt D in order to realign its leverage target to 10, which leads to:

Leverage = Assets = 101 + D = 10, solving for D gives, D = 9

Equity 11

Thus the firm must take on additional debt worth 9, and use this new capital to purchase

securities worth 9. The relatively benign increase in the price of the initial security by 1

forces the bank to increase debt by 9 in order to realign the leverage back to 10:

Assets Liabilities

Securities, 110 Equity, 11

Debt, 99

The same example applies in the reverse scenario where the asset decreases by 1. For

example, the value of the above security decreases to 109.

Assets Liabilities

Securities, 109 Equity, 11

Debt, 99
The firm is now in a scenario where its leverage is too high (109/10 = 10.9). Since the

value of the debt remained constant entering this situation, the bank readjusts its leverage

to its target of 10 by selling 9 worth of securities and paying off 9 worth of debt. The

relationship here is similar to that described earlier for the value at risk relationship,

where as the price of the asset (security) falls, as in a market downturn, the firm responds

by selling the security and restoring the balance sheet to its initial positions, with a

leverage target restored to 10:

Assets Liabilities

Securities, 100 Equity, 10

Debt, 90

Several authors have described an amplification of the financial cycle when

feedback from other firms interacts with the rebalancing of an individual firm’s leverage

to balance falling asset prices (T. Adrian & Shin, February 2008; A. Krishnamurthy,

September 15, 2008; A. Krishnamurthy, 2003). This phenomenon is portrayed in figure

1 and shows that in a strong financial market with greater demand for assets, prices of the

assets increase, resulting in stronger balance sheets for firms involved in buying and

selling the assets. However, in downturns, when there are fewer buyers than sellers, the

asset prices decrease, balance sheets weaken, and leverage increases. In order to reduce

leverage, firms will sell assets, and use the proceeds to pay off debt, as was seen in the

previous example. This scenario causes the decreasing price of the asset to lead to an

increase in the supply of the asset, which does not follow a normal supply and demand

response. The feedback effect becomes even more significant as weaker balance sheets

again lead to greater sales of the asset, depressing the asset’s price further, leading to
 even weaker balance sheets. The downturn can spiral out of control for firms who held

initial positions in the now devalued assets as balance sheets are basically liquidated at

ever falling prices as demand continues to fall. The downward spiraling market for the

asset, combined with the aggregate effect of several firm’s persistent and simultaneous

restoration of balance sheet target leverage can create an asset that is seemingly illiquid

(Brunnermeir & Pedersen, June 2008).

Figure 1. The Leverage Amplification Loop:

Target Leverage Target Leverage

Stronger Balance Increase Balance Weaker Balance Decrease Balance

Sheets Sheet Size Sheets Sheet Size

Asset Price Boom Asset Price Decline

In the current financial crisis, active balance sheet management appears at first
 glance to not have contributed too significantly to the deteriorating conditions. In a

recent analysis, Greenlaw et al. compared the average value at risk (VaR) data over the

last three months of each of the major investment banks. The VaR of the four major

banks had more than doubled within two years, while their balance sheets did not

experience an expected contraction. Given the previous discussion of a bank’s

management of their balance sheet to control their overall leverage and VaR, one would

expect that in the current downturn, as perceived risks are high, banks would decrease

leverage, since their VaR was rising, thereby contracting their balance sheets. However,

the data in Table 2 shows that throughout the crises, VaR increased significantly and

according to several reports, balance sheets did not immediately contract (Greenlaw,

Hatzius, Kashyap, & Hyun, 2008). Generally, when the balance sheet of a bank is strong,

they will hold excess capital, which they seek to employ by ramping up their leverage.

To do this, banks issue short-term debt (commercial paper) on the liabilities side and

search for potential borrowers to lend to on the asset side (T. Adrian & Shin, February

2008). A proposed reason for the rapid expansion of balance sheets and VaR is that

banks were urgently looking to employ their excess capital during the explosion in real

estate prices, which provided a market of borrowers who were inappropriately granted

credit, since the majority of sub-prime mortgage borrowers, had little means to repay the

loans.

Table 2. Average Daily Value at Risk over previous 3 months of four major investment
banks.
May-06 Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07 Feb-08

Index of VaR 1 0.89 1.05 1.29 1.38 1.58 1.95 2.12

Source: Adapted from (Greenlaw et al., 2008), representing the authors calculations using reported figures
from Bear Stearns, Goldman Sachs, Lehman Brothers, and Morgan Stanley.
 The apparent disparity between the doubling of VaR and persistence of an

expanding balance sheet may be due to the ongoing uncertainty of banks in assessing the

creditworthiness of their borrowers. Leading up to the crisis, banks had begun to increase

their lending to nonbank borrowers, assessing a premium to these loans based on the

creditworthiness of the borrower. They held an increasingly large portion of their assets

in mortgage backed securities and structured investment vehicles, which they funded by

issuing commercial paper. Uncertainty developed in the summer of 2007 regarding the

falling value of mortgage backed securities, and banks subsequently had trouble meeting

the liabilities of the commercial paper they issued, since these were backed by the now

falling price of the mortgage securities. The valuation of the sub-prime assets was

virtually impossible, because banks and lenders had no mechanism to assess who would

repay and who would default on the loans. Banks became so unsure of how to value their

own assets let alone the assets of those they were lending to, that the commercial paper

they needed to issue, backed by the sub-prime mortgage securities, become virtually

worthless and they were unable to issue it. Banks in turn could not rely on their usual

financing activities of issuing collateral backed commercial paper and they eventually

halted lending altogether, in order to decrease their VaR, contracting their balance sheets

rapidly and hoarding cash so that the could meet their immediate liabilities. This led to

the perception of an aggregate and virtually instantaneous credit crises, and the necessary

balance sheet contraction, although it seemed to occur much later than would have

normally been expected (Barrell & Davis, 2008; Greenlaw et al., 2008). In response to

the nearly simultaneous contraction of the majority of bank’s balance sheets around the

world, central banks injected liquidity into the system to encourage banks to once again
expand their balance sheets and return market conditions to “normal”. However, banks

were so short of capital, over-leveraged, and laden with securities of questionable

valuation, that the return to normal of interbank lending, and even consumer lending has

been extremely protracted.

The active management of balance sheets via financial institutions adjusting the

effects of marking assets to market prices and maintaining a specific leverage and value

at risk have clearly played a significant role in the current financial crisis. The insistence

to employ excess capital was so great, that the market for sub-prime mortgages led

financial firms to expand their balance sheets so rapidly that borrowers with questionable

credit risk were inappropriately granted loans. Individual firms understandably have

specific guidelines of measuring and maintaining their value at risk by adjusting leverage

and either expanding or contracting their balance sheets. This mechanism may have

significant consequences for the entire financial system. However, the combined effect

of these modifications when firms are holding similarly devalued securities can have

devastating consequences in times of economic downturns as a network of firms may

simultaneously contract their balance sheets in order to reduce their risk of loss or VaR.
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contagion. Banque De France Financial Stability Review, 11(Special

Issue on Liquidity), 1-7.

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financial cycles. Current Issues in Economics & Finance, 14(1), 1-7.

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