How the StatPro Dynamic Risk Model predicted the downfall of
Lehman and WaMu
Please note: This paper was authored by Dario Cintioli
on 15th September 2008, prior to the collapse of Washington
Mutual
In our case study about
Bear Sterns, we explained how the StatPro
dynamic model anticipated the Bear Stearns crisis, following the
fast increase of credit default swap (CDS) spreads. The case study
was also comparing the behavior of different issuers to the one of
Bear Stearns and it clearly showed that only Lehman Brothers -
among the selected issuers - followed the increase of risk of the
Bear Stearns bonds.
This second case study first analyzes the evolution of VaR of
one Lehman Bond, comparing it with the 5-yrs CDS.
The second part of this paper is dedicated to a potential future
victim of the current crisis, Washington Mutual Inc. The staggering
credit spreads paid by WaMu Inc. in the market speak for
themselves: almost 6,000 bps in the 1-yr CDS.
Lehman Brothers
The graph below compares the evolution of the CDS-5yrs close value
of Lehman Brothers (in pink) to the VaR 99% 1-day of a bond issued
by Lehman and maturing on Sep-2014, 6.20% coupon (in blue). The
observed period ranges from close date of 31st Dec 2007 to 10th of
September 2008.
The previous case study on Bear Stearns illustrated that the
peak of March 2008 was an idiosyncratic event, affecting Lehman
Brothers (and Bear) specifically. At that time, after the collapse
of Bear Stearns, Lehman was in fact seen as the next victim. The
peak was reached on the 14th-17th of March, with CDS spread
increasing 4-fold and VaR almost 3-fold from beginning of the
year.
VaR suddenly decreased from the peak levels the day after (18th
of March), and decreased in May-June following the bear-rally.
The increase of VaR that followed afterwards is only modest, as
the credit spread of Lehman increased, but no more than other
financial issuers.
Differently, in the last two days drawn in the graph, the CDS
spread suddenly exploded (idiosyncratic movement), moving from 325
(8th of September) to 570 (10th of September). Accordingly, our
risk figure moved from 1.52% of the 8th of September to 2.34% of
the 10th of September.
The real billion dollar question here is why
the CDS market did not increase credit spreads before and by
more?
The answer is that the market was expecting a rescue and
operated with Bear Stearns in mind. In the case of Bear Stearns the
losers have been the stockholders and the big gainers the
bondholders. That is why Lehman's stock collapsed while the credit
spreads increased more moderately and less suddenly.
The market bet was that the sure rescue (the thinking went:
"they saved Bear, Fannie and Freddie, they will save also Lehman")
would have penalized the stockholders and saved the bondholders.
How wrong this bet turned out to be …
Is Washington Mutual the Next Big One?
Based upon a number of articles in the press discussing its
weaknesses, we have selected and analyzed the behavior of the VaR
99% 1-day of a fixed coupon bond in USD expiring on May-2015,
coupon 5.25% issued by Washington Mutual Incorporated.
We have used the historical data starting from the beginning of
the year. The Graph below draws the evolution of the risk figure
for the bond.
The graph illustrates that the StatPro VaR for this bond
increased constantly during the first 3 months of the year,
reaching a peak in March, in line with the Bear Stearns
rescue.
Quite impressively, the Risk figure went down quickly in May to
reach the same levels of the beginning of the year. From that
moment onwards the Value-at-Risk has constantly increased, marking
new highs at the end of July and a few days ago.
Please note that the VaR 99% 1-day for this 7-year bond stands
today at an impressive 7%.
The comparison of this risk measure with the CDS 5-yrs spread
gives us more hints.
Like in the Bear Stearns and Lehman case, our VaR figure has
followed the evolution of the CDS market (in pink) and moved
accordingly. The high levels of VaR and CDS spreads are currently
forecasting hard times for this issuer: the 5-yrs spread of WaMu
Inc. (2,250, 12-Sep-2008) is now much higher than the 5-yrs CDS
spreads of Bear (720) and Lehman (700) the day before their
respective credit events. Is it Washington Mutual's turn next?
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