The Lehman Fiasco

10 Things Pension Funds Need to Know…

A NEW DESTINATION FOR

ASSET & LIABILITY MANAGEMENT

18th September 2008

Lehman Fiasco

10 Things Pension Funds Need to Know


Redington Partners 18th September 08


1. In practice, what happens when a swap counterparty vanishes?

2. What are the risks associated with replacing a terminated swap?

3. What do these events tell us about LDI?

4. How to manage counterparty risk?

5. How will this impact the value of the pension fund’s other assets?

6. How has the market reacted in the last three days?

7. Can the markets get any worse?

8. What should I be asking my asset manager?

9. Could this happen to any other banks?

10. What are the lessons for risk management?

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Lehman Fiasco

10 Things Pension Funds Need to Know

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What happens when a swap counterparty vanishes?

Mark-to-Market (MTM) of

Outstanding Swaps

• Determine exact moment of bankruptcy:

• Value outstanding collateral;

• Obtain 5 bank Quotes to value all outstanding swap positions;

• Or determine “Loss”.

Determine net payment flows

• Net all outstanding swap contracts with bankrupt counterparty.

•If net payments owed to pension fund, collateral claimed.

•If collateral insufficient, shortfall is unsecured claim in bankruptcy.

•If net payments owed to counterparty, pension fund releases collateral to counterparty.

New Swaps/Hedges

•Execute new replacement swaps at current market levels; or

•Buy bonds (Government/inflation) wait for more favourable market conditions.

•Do nothing - Run market risk.

Swap Collateral

Investment Banks

• Investment banks are providing clients

with a poll of swap prices to help

determine close out levels with Lehman.

• They are also market making on

replacement trades for clients.

• Lehman was not a major LDI

counterparty but by some estimates

they had over £3m PV01 of RPI

exposure and much more in nominals.

• On Monday, 15 Sep ‘08, an estimated

50% to 60% of this was traded which

pushed swap break-evens 10bps

higher.


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What are the key risks / costs associated with replacing a swap?

• Potential shortfall between value of collateral and MTM of swap value;

• Bid / offer spread charged on replacement transaction;

• Open market risk from time of bankruptcy until new hedge implemented;

• Availability of replacement swap given illiquid market conditions.

Breakevens implied by swaps were

sharply higher in the long end with 30yrs

trading at the psychologically important

4.00% level (up 11bps on the day).

Replacement of Lehman Risk (est.) in the Market (change in RPI Swap Curve)

Source: Bloomberg / Redington


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Lehman Brothers UK Defined Benefit Pension fund Liquidator Expenses

Fixed Secured Creditors

Pension fund deficit*

Floating Secured Creditors

Unsecured Creditors

Shareholders

* Liquidator obligated to fund to Scheme Specific Funding level (generally a slightly more prudent basis than IAS19)

Asset Value IAS 19 PV Liabilities

Buyout Price % of Assets

Actives and Deferreds

£164 £183 £214 130%

Pensioners £16 £17 £18 113%

Total £180 £200 £232 129%

• Join ranks of creditors.

• Windup the fund – PPF or private insurer with reduced benefits.

• High number of Deferreds and Actives (over 96% of total fund members). This will increase the longevity risk associated with private buyout quotes.

• If adopted by PPF, existing pensioners will continue to receive current benefits. All other members’ benefits will be capped at a maximum of £27,770 per annum.

Breakdown of Lehman’s Estimated Buyout Costs (£ Millions)

Source: Redington - All figures based on (limited) publicly available information and assumption / example of 90% level of IAS 19 funding. No info available on this point.


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What does this tell us about LDI?

• Swaps enable pension funds to manage two major risks – interest rates and inflation;

• Unavoidable corollary is counterparty risk. This is mitigated as both parties post collateral; • Like house insurance, prudent LDI remains essential. Recent events simply highlight the importance

of understanding risk, selecting and managing secure protection providers.

LDI shuts down pension fund’s exposure to:

LDI exposes pension funds

to:

Rise in Inflation Expectations (last 5 years)



Managing counterparty risk 1. Minimise exposure through tightening CSA conditions

• Credit risk can be reduced by: • Reducing the time between collateral calls; • Limiting the types of securities that can be posted as collateral to cash and government bonds; • Reducing minimum collateral thresholds to zero.

• These agreements are typically “two way”, which may place an additional administrative burden on the pension fund and/or its fund managers.

• A "distressed" counterparty may agree to more stringent conditions in one direction (i.e. when they post collateral). 2. Re-coupon swap transactions to current mid-market value • Swap transaction terms should be regularly “updated” such that the hedging bank pays an upfront cash amount to the

pension plan thereby reducing the prevailing mark-to-market value to (or close to) zero, i.e. it settles up its account. • For this to work, swaps should be re-couponed to have broadly the same interest rate and inflation sensitivity as

previously. • This is not the same as posting collateral which does not involve re-couponing the original transaction.

Advantages • Frees up cash to invest in assets to generate a return above LIBOR; • Reduces credit exposure to swap counterparty; • If the collateral is restricted to cash / government bonds then the improvement in credit risk may be marginal, but

(depending on funding position/reserving policy / method of calculating current mark-to-market) the hedging bank may be able to pay a greater value than the current mid-market value;

• If the CSA allows a greater range of collateral (for example, corporate bonds), then re-couponing is likely to achieve a meaningful reduction in credit risk given the lack of price transparency of such instruments in the current environment.

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Disadvantages • Given that the re-couponed swaps have zero present value today, there is some likelihood that the pension fund will

have to post collateral to the hedging bank in future – which may, perhaps, be considered a disadvantage.

3. Novate or assign swaps to new swap counterparties • Pension fund completely replaces hedging bank counterparty in swap agreement. New swap counterparty executes

"back to back" swap with old swap counterparty. Advantages • Diversifies credit exposure, providing potentially stronger credit counterparty and reducing exposure to any one bank.

Disadvantages • Banks will charge a fee for intermediating a swap which, in the worst case, may be of a similar order of magnitude to

implementing a completely new swap. • The new potential bank counterparty may not want to face the existing counterparty (e.g.: this may be the case if the

existing swap counterparty is distressed or the new bank counterparty already has a large exposure to it). • The new bank counterparty may not be able to offer the same degree of post-transaction liquidity as the old

counterparty if the trade is subsequently changed/closed out.

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Managing counterparty risk


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How will these events impact the value of the pension fund’s other assets?

Asset Class Impact

Equities Negative. All markets are falling, with financial stocks hardest hit.

Corporate Bonds Negative. Credit spreads ballooning as market participants revalue counterparty risk.

Government Bonds Positive at the short end, neutral at the longer end.

Property Negative.

Inflation Gilt Breakeven vs Swaps Breakeven

Gilt breakeven is lower on back of falling oil prices but swap breakeven moving higher on back of demand for new (replacement) hedging activity (see p5 above).

Cash Positive. Libor remains well above official short term rates offering an attractive “flight to quality” haven in the face of volatile markets.

Hedge Funds Varied. Generally negative.

Asset Backed Securities / Illiquid structured credit (“Proxy Cash”)

Negative. As Lehman assets are fire-sold new lower valuations will be established for that asset class. The very act of selling will drive values lower.


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How has the market reacted?

Market Reaction Change Since Monday 15/09/08

UK Equities (FTSE 100) -9.3%

US Equities (S&P 500) -7.6%

Interest Rates (30 Year Interest Rate Swap)

-8bps

Long Term Inflation Expectations (30 Year Inflation Swap Rate)

+7bps

Credit Spreads (5 Year iTraxx) +41bps


Spreads on 10 year Goldman Sachs Credit Default Swaps (CDS)

Collapse of Northern Rock

Withdrawal of liquidity in

interbank market

Bear Sterns bought out by JP

Morgan

Lehman Brothers file for bankruptcy.

Bank of America announces purchase

of Merrill Lynch

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Historical FTSE 100 Performance (2000 – 2008)

Can the markets get any worse?

Low: 3,287 (12 March 03)

High: 6,640 (18 May 07)

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CDO crisis

Northern Rock nationalised

Bear Sterns bought out by JP Morgan

Lehman Brothers files for

bankruptcy. Fed leaves short term rates unchanged

Can the markets get any worse?

Overnight GBP LIBOR


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What should I be asking my asset manager? • Pension funds should seek to understand:

• Their counterparty exposure to: • US Investment Banks; • UK and European Investment Banks; • Other Financial Companies (e.g. Insurers); • Asset manager strategy in current market conditions.

• For each of the above, Redington would recommend funds monitor:

• Notional Exposure; • CDD1 (Credit Duration); • Recovery Values; • ISDA Schedule Terms; • ISDA CSA Terms. • All Asset Valuations

• The current environment makes it very difficult to liquidate. Therefore, we recommend:

• Where possible, recoup any cash balances associated with swaps; • Reinvest any funds in low risk assets, e.g. short dated gilts, or long dated

(index-linked) gilts if the fund has remaining PV01 mismatches.


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Could this happen to any other banks?

Financial Stocks Under Pressure Movement in Share price w/c 15th Sept 2008

AIG -83%

Washington Mutual -26%

Goldman Sachs -26%

HBOS -48%

Very few degrees of separation

•Lehman Brothers’ London landlord, Songbird Estates Plc, insured 4 years of rent payments on Lehman’s offices in the Canary Wharf financial district. Insurer? AIG.


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What are the lessons for risk management? • Learn to respect mark-to-market; • View Risk through several “lenses”;

• Reduce unrewarded risk;

• Examine portfolio strategy;

• Establish Framework to move quickly.

Before AIG reported its second-quarter results,

analysts estimated deterioration in the market may

have required realized losses of as much as $3.25

billion in an unlikely, worst-case scenario. AIG had no

write-offs, and said it expects to collect “substantially

all principal and interest.''

``AIG views recent pricing as indicative of market

turmoil unrelated to the fundamental financial

characteristics of these securities,'' Lewis said, calling

the declines “temporary"

AIG August 2007


Contacts

Dawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 3415 [email protected] Robert Gardner | Partner Direct: +44 (0) 207 250 3416 [email protected] Redington Partners LLP 13 -15 Mallow Street London EC1Y 8RD Telephone: +44 (0) 207 250 3331

www.redingtonpartners.com THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT

Disclaimer For professional investors only. Not suitable for private customers.

The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this message is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence .

Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions is the sole responsibility of the Trustees' actuarial advisors. Redington Partners will estimate the liabilities if required but will not be held responsible for any loss or damage howsoever sustained as a result of inaccuracies in that estimation. Additionally, the client recognizes that Redington Partners does not owe any party a duty of care in this respect.

Redington Partners are investment consultants regulated by the Financial Services Authority. We do not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate.

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Economy & Finance

The Lehman Fiasco