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					          Systemic Risk:
          The events of 1998 from
          an industry perspective
                Wilson Ervin
                Chief Risk Officer

                                                              The opinions expressed herein
                                                              are solely those of the author,
                                                              and not necessarily those of
                                                              Credit Suisse
CREDIT SUISSE                                                                      Produced by: Research
                                     CREDIT SUISSE PRIVATE BANKING                   Date: Q12006 Slide 1
Introduction

 Defining Systemic Crises
  –   Events that impact the system, not just individual counterparties or a market.
  –   e.g. bank “runs”, market “gridlock”, crisis of confidence, failure of key utilities.
  –   In some definitions, also critical to impact the underlying real economy
  –   The normal rules and boundaries of usual market function are in question


 Possible Candidates
  – 9/11: „Is the payment system going to work? Will confidence return?“
  – Post Tech-Bubble Correction (2002-03).
  – Russia/LTCM: „Markets keep getting worse and less liquid. Will this
      continue? Are my counterparties solvent?“
  – [Avian Flu – „Can I run my business if nobody comes to the office?“]


                                                                          Date: 18 May 2006 Slide 2
Russia Crisis:
Joint Announcement of the Government & Central Bank (8/17/98):
   – Devaluation of Ruble (previously pegged)
   – Implementation of capital controls
   – Restructuring of Local Currency Debt

CSFB research comment from that period:
    “ A major surprise to the market . . . CSFB had certainly not
     expected Russia to devalue, default and restrict convertiblity
     at the same time; one of the 3, but not all 3 at the same
     time.”

Some estimates that market participants lost $100bn


                                                         Date: 18 May 2006 Slide 3
Russian debt default (hard currency bond prices)
                                         210                                     210


                                         180                                     180
    JP Morgan EMBI Global Russia Index




                                         150                                     150


                                         120                                     120

                                                                   80% drop
                                         90                                      90


                                         60                                      60


                                         30                                      30

                                                  Russia Default
                                          0                                       0         Source:
                                          06.97         06.98                 06.99         Datastream



                                                                                      Date: 18 May 2006 Slide 4
Russian currency devaluation
                                                                  Source: Bloomberg
                           0.20
                                                  Russian Govt
                           0.18
                                                  Announcement
                           0.16

                           0.14
     Value of RUB in USD




                           0.12

                           0.10
                                                       70% drop
                           0.08

                           0.06

                           0.04

                           0.02

                           0.00
                                  06.97   06.98                        06.99



                                                                       Date: 18 May 2006 Slide 5
                        LTCM Returns – the good years

                               LTCM Returns (after fees)       Highly prestigious global hedge fund
                        45%

                        40%
                                                               Very large (>100bn in assets)
                        35%

                                                               Sophisticated, arbitrage oriented
% Return (after fees)




                        30%

                        25%

                        20%
                                                               Highly leveraged (>25-1 in early 1998)
                        15%

                        10%
                                                               Moderate net realized volatility
                        5%

                        0%
                              1994    1995     1996    1997
                                                                    (target was risk of S&P 500)
                                                               Excellent returns in first 4 years


                    Source: P. Jorion “Lessons of Long Term Capital Management


                                                                                        Date: 18 May 2006 Slide 6
Spread expansion
                   250
                                                                                                              Source: Datastream


                   200


                                    US Corporate Spreads
  Corporate to 10y UST




                   150



                   100


                                    US Swap Spreads
                         50



                                                                 Russia Default         LTCM
                         0
                         06.97                                            06.98                                         06.99

                          Series3                                                 Series2
                          Spread of US Avg Corporate vs US 10y Treasury           US 10y Swap vs US 10y Treasury


                                                                                                                   Date: 18 May 2006 Slide 7
Volatility of S&P 500 (market implied)
             50

             45

             40

             35
  CBOE VIX




             30

             25

             20

             15

             10

             5
                             Russia Default   LTCM
             0
             12 96   12 97                      12 98                        12 99
                                                        Source: Datastream


                                                                       Date: 18 May 2006 Slide 8
             Estimated Source of LTCM Losses


         Investment                                        Loss ($mm)
         Russia and other emerging markets                    430
         High-yield (junk bond) arbitrage                     100

         Standard & Poor's 500 stocks                         203
         Equity pairs trading                                 286
         Equity volatility bets                              1300

         Directional trades in developed countries            371
         Yield-curve arbitrage                                215
         Interest swaps                                      1600


Source: R. Lowenstein “When Genius Failed: The Rise and Fall of LTCM”


                                                                        Date: 18 May 2006 Slide 9
 LTCM Returns (cont’d)

                              60%

                              40%

                              20%
     % Return (after fees)




                               0%

                             -20%

                             -40%

                             -60%

                             -80%

                             -100%
                                     1994 1995 1996 1997 Jan   Feb   Mar   Apr   May   Jun   Jul   Aug   Aug
                                                         98    98    98    98    98    98    98    98    98

Source: P. Jorion “Lessons of Long Term Capital Management


                                                                                                         Date: 18 May 2006 Slide 10
Financial stocks down 50% (fairly representative
sample)
            JP Morgan Chase                                              Lehman

   70                                      70           30

   60                                      60           25

   50                                      50
                                                        20
   40                                      40
                                                        15
   30                                      30
                                                        10
   20                                      20
                                                         5
   10                                      10
           Russian default       LTCM                                Russia Default    LTC
   0                                        0            0                              M
   06.97          06.98                 06.99            06.97             06.98                             06.99

                                                                       Bear Stearns
                 Credit Suisse
                                                        60
   90

   80
                                                        50
   70

   60                                                   40

   50
                                                        30
   40

   30                                                   20
   20
                                                        10
   10
               Russia Default    LTCM                                 Russia Default   LTCM
   0
                                                         0
   06.97             06.98                06.99
                                                         06.97             06.98                            06.99


                                                Source: Datastream
                                                                                             Date: 18 May 2006 Slide 11
LTCM period

 Prices moved outside of “normal” ranges and continued to slide
 Normal stabilizers not working - no new “risk capital” entering
    market (most trying to exit)
 Bank management under pressure to avoid risk of further loss
   Forced liquidation of leveraged positions
   Volume declined in many markets, in some cases dramatically
   Rumors of major financial institutions under pressure
   Increase in derivative exposures and risk of contagion
   Crisis continued for a period, even after LTCM rescue


                                                            Date: 18 May 2006 Slide 12
Comments & Conclusions




Source: Datastream


                         Date: 18 May 2006 Slide 13
Conclusions

Systemic events are not just the „fat tails“ of normal markets;
rather they involve fundamentally different processes & actors
Most risk processes and market behavior assumes that markets
have a stable distribution – need to be wary around that
assumption.
Markets will often converge to trades that provide profits assuming
that certain market features are reliable in a given system; high
value placed on stability of earnings. This stablity can be
threatened when trades get overcrowded.
No static „magic formula“ to deter systemic risk. An adaptive
system will need an adaptive response.
                                                                    Source: IB



                                                        Date: 18 May 2006 Slide 14
Growing importance of hedge funds
 Number of funds                                                                                                                                                 USD bn
 12000                                                                                                                                                             1600


                                                                                                                                                                   1400
 10000

                                                                                                                                                                   1200

  8000
                                                                                                                                                                   1000


  6000                                                                                                                                                             800


                                                                                                                                                                   600
  4000

                                                                                                                                                                   400

  2000
                                                                                                                                                                   200


     0                                                                                                                                                             0
         1990      1991   1992   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006    2007   2008   2009    2010



                                                       Number of Hedge Funds                                    Hedge fund assets
 projected 10% growth p/ a
                                                                                                                                                         Source: HFR



                                                                                                                                            Date: 18 May 2006 Slide 15
Current Conditions: Swap vs Corporate Spreads

     350


     300


     250


     200


     150


     100


      50

           Russia Default LTCM
      0
      12.96     12.97     12.98     12.99     12.00    12.01     12.02     12.03   12.04   12.05
                                  Series3
                                  Series4
                                  Spread of US Avg Corporate vs US 10y Treasury
                                  US 10y SWAP vs US 10y Treasury

                                                                                            Source: Datastream



                                                                                             Date: 18 May 2006 Slide 16
Current Conditions – Equity volatility

                      50

                      45

                      40

                      35
           CBOE VIX




                      30

                      25

                      20

                      15

                      10

                      5
                                                  Russia Default  LTCM
                      0
                      12 91 12 92 12 93 12 94 12 95 12 96 12 97 12 98 12 99 12 00 12 01 12 02 12 03 12 04 12 05
 Source: Datastream


                                                                                                         Date: 18 May 2006 Slide 17
Current Conditions – Emerging Markets
       JP Morgan EMBI Global Sovereign Spread   1800

                                                1600

                                                1400

                                                1200

                                                1000

                                                800

                                                600

                                                400

                                                200 Russia
                                                             LTCM
                                                  0 Default
                                                  12.97 12.98 12.99 12.00 12.01 12.02 12.03 12.04 12.05

Source: Datastream


                                                                                                      Date: 18 May 2006 Slide 18

				
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