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Give instances of funding liquidity risk and the funding sources involved, and draw out what the Northern Rock, Ashanti Goldfields and Metallgesellschaft episodes taught.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Liquidity Risk · FRM2.LTR.1.b

The idea

Funding liquidity risk is the risk that a firm cannot meet cash obligations when due, or can do so only at distress cost. It arises from maturity mismatch and from reliance on short-term sources. These include wholesale deposits, repo, commercial paper, interbank lines, and collateral or margin calls on derivatives. Insured retail deposits and long-term debt are stickier. Northern Rock, the UK mortgage lender, financed long assets with wholesale and securitisation funding that closed in 2007, and a retail run followed. Ashanti Goldfields, a gold producer, suffered cash demands on its derivative hedge book when gold spiked in 1999. Metallgesellschaft's US oil unit hedged long-dated fixed-price contracts with rolled short-dated futures in 1993. Falling prices created large variation margin calls. The lesson is that profitable hedges can still exhaust cash.

A practice question

From the question bank, with the reason each wrong option is wrong.

What was the main cause of the 2007 liquidity crisis at Northern Rock?

  1. Large trading losses on a proprietary credit derivatives book eroded its capital base and triggered a flight of funding.Why not: Invents a trading-loss cause; Northern Rock's problem was funding mismatch, not a trading book.
  2. It funded long mortgages with short-term wholesale and securitisation funding that closed, then depositors ran. - correct
  3. Variation margin calls on a hedge book of commodity futures drained its cash and forced asset sales.Why not: Confuses Northern Rock with Metallgesellschaft or Ashanti, whose problems were margin calls on hedges.
  4. A sovereign default froze the government bonds it held as its stock of liquid assets, so it could not raise cash.Why not: Invents a sovereign default; no such event caused the run.

Northern Rock relied on wholesale markets and securitisation to fund mortgages; when these markets closed in 2007 it needed central bank support, and news of that triggered a retail deposit run.

A harder one

Metallgesellschaft's US oil subsidiary sold long-dated fixed-price delivery contracts and hedged them with short-dated futures that were rolled forward. When oil prices fell in 1993, what was the key funding liquidity lesson?

  1. Futures were marked to market only at maturity, so losses stayed hidden until the contracts were delivered.Why not: Futures settle daily, which is what produced the variation margin; losses were not deferred.
  2. Customers defaulted on the fixed-price contracts, which removed the inflows the hedge programme had been expected to receive.Why not: Wrong risk: the strain came from margin calls on the hedge, not from credit losses on customers.
  3. Daily futures losses meant margin calls, while the gains on the long-dated contracts were unrealised: a cash-flow mismatch. - correct
  4. Prices rose, so the short futures position required margin while the delivery contracts gained value for the firm.Why not: Direction and position error: it held long futures against short physical commitments, and prices fell.

The firm was short long-dated physical commitments and long rolled futures. Falling prices produced daily futures losses and cash calls, with the economic gain on the commitments not received in cash. The hedge was sound economically, but unfunded.

The hardest tier

A Metallgesellschaft-style firm has sold fixed-price forward contracts for 80 million barrels and hedged them one-for-one with long positions in near-month futures. Futures prices fall by USD 5 per barrel. Which statement describes the immediate cash position?

  1. A variation margin outflow of USD 16 million, found by dividing 80 million barrels by the USD 5 per barrel move.Why not: Divides barrels by the price move instead of multiplying them.
  2. No net cash flow, because the USD 400 million futures loss is exactly offset in cash by the gain on the forwards.Why not: Treats the economic offset as a cash offset; the forward gain is unrealised until delivery.
  3. A cash inflow of USD 400 million, because falling prices raise the value of the long futures hedge position.Why not: Sign error: a long futures position loses when prices fall, so margin is paid, not received.
  4. A USD 400 million margin outflow (80 million x 5), with no cash receipt as the forward gain comes only on delivery. - correct

Long futures lose 5 x 80 million = USD 400 million, settled daily as variation margin. The offsetting gain on the fixed-price forward contracts is realised only as deliveries are made, so cash is drained now.

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