US Banks, Contagion Effect and Systemic risk: Evidence in the wake of the LTCM near collapse.

Sarvesh Mehta MSc Finance and Economics Student ID: 0851273 Supervisor: Xing Jin

ACKNOWLEDGEMENTS I would like to thank my supervisor Mr Xing Jin for his valuable comments and guidance. I would also like to express my appreciation to all my lecturers and staff at Warwick Business School. Finally, I would like to thank my parents and family for their constant support and encouragement.

All the work contained within is my own unaided effort and conforms with the Universitys guidelines on plagiarism.

CONTENTS

1) 2) 3) 4)

Abstract..........................................................................................................................Pg 2 Introduction....................................................................................................................Pg 3-7 Review of Literature........................................................................................................Pg 7-11 Data and Methodology

4.1.1) Main Model..................................................................................................................Pg 11 4.1.2) Systemic Risk Effect Model............................................................................................Pg 12 4.2) Event Selection................................................................................................................Pg 12-13 4.3) Data Collection................................................................................................................Pg 13-14 4.4) Methodology...................................................................................................................Pg 14-15 5) Empirical Results and Tables.................................................................................................Pg 16-22 6) Conclusion............................................................................................................................Pg 23-24 7) Bibliography.........................................................................................................................Pg 25-27 8) Appendix..............................................................................................................................Pg 28-37

ABSTRACT The long term capital Management debacle was a cause of concern for many financial institutions worldwide. In 1998, the failure of the worlds largest Hedge Fund nearly destroyed the US financial industry. The fund was founded by John Meriwether in 1994 with a group of partners that included two noble prize winners and some of the most eminent names in the field of economics and finance. Due to the academic prestige of the founders, and their background in arbitrage trading at Salomon Brothers, LTCM quickly developed an aura of mystique and invincibility that was unrivalled on Wall Street. (When Genius Failed by Roger Lowenstein). The fund gave phenomenal returns to all the investors before 1998 which kept them away from raising fingers at the lack of transparency of the fund. In 1998, the failure of the worlds largest hedge Fund mainly due to its poor risk management and lack of regulations forced the Federal Reserve Bank of New York to assist a bailout to the fund, fearing that the liquidation might shatter the global markets. As many as fourteen banks took part in the massive bailout. The impact of the LTCM crisis on the stock prices of the participating banks and financial institutions was immense. Stock prices of financial institutions participating in the bailout dropped by over 21% from the time of LTCMs announcement of losses through the bailout period (Jill L.Wetmore, 2007). This paper studies the possibility of contagion during the bailout phase which is revealed by significant negative returns by US banks and financial institutions with no investment or loans to LTCM. Although this decline was less severe compared to the banks that were a part of the bailout. The paper also examines the impact on systemic risk (during and after crisis period) given the magnitude and influence of the crisis. The results of this study are similar to the earlier studies despite the exclusion of non U.S. Banks.

INTRODUCTION Since the mid-1990s financial markets all over the globe have witnessed several crises. During this crisis, the main concern for many market participants has been the spillover in other global markets and economies. This is evident from the LTCM crisis of September 1998, causing increased volatility across the banking and financial sector both in US and other parts of the world. This phase of distress and chaos starting from the Russian default and the LTCM crisis was short, spanning only a few weeks. However, the effect was felt all over the financial world. This raises important questions about the nature of spillovers and contagion. The linkage through which the transmission of shocks takes place may be pinned down at times, while at other times there seems to be an absence of apparent links (Cheung, Chi-sang Tan et al.., 2009). LTCM like the Titanic was thought to be unsinkable and was designed by the most prominent and respected names in finance and economics to be the ultimate hedge fund. The first four years of the fund gave staggering returns to its investors and kept them satisfied.

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

In 1998, a number of LTCM market bets turned out to be faulty and severe losses occurred. These abnormal losses seriously weakened the capital spot of LTCM. The management predicted that the interest rates between corporate bonds and US treasury securities would slender after the Asian crisis of 1997. Instead, the gap increased contrary to their expectations as shown below.

250

200

Corporate to 10y UST

150

100

50

0 06.97 Series3

Russia Default 06.98

LTCM 06.99

Series2 US 10y Swap vs US 10y Treasury

Spread of US Avg Corporate vs US 10y Treasury

Source: DataStream

Failure of LTCM can be attributed to numerous factors. The most important among them was the lack of Risk Management. LTCM had the most refined hedging strategies. LTCM was also the most highly leveraged hedge fund in the history. LTCM used a combination of VaR Models which laid emphasis on past data to predict future price movements given that the market conditions remain normal. In August 1998, an unexpected non-linearity occurred that was beyond the detection scope of the VaR models used by LTCM (Davis, 1999). Russia defaulted on its debt, resulting in drying up of liquidity in the global financial markets. The LTCM VaR models underestimated daily loss of the fund to be no more than $50 million. However, the fund was
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losing double the amount every day. As a result LTCM management started preparing for bankruptcy announcement. However, US Federal Reserve, fearing that LTCMs collapse could paralyze the entire global financial system due to its enormous, highly leveraged derivatives positions, extended a $3.6 billion bailout to the fund, creating a major moral hazard for other hedge funds (Dong et al, 1999).

Another decisive factor in LTCMs failure was the correlation between assets. During 1998 there was a plunge in correlations, for example in the correlation between Corporate and Treasury Yields, whick led to a rise in portfolio volatility (Jorion, 2000). This unexpected event was beyond the scope of the management and hence these sudden changes were not taken into account and LTCMs portfolio volatility was way higher than what their models were suggesting at that time.

The loss announcement occurred on September 2, 1998 and within a couple of weeks bailout took place. The dates surrounding the official announcement and the bailout period are considered key event dates in this study. Goldman Sachs, AIG and Berkshire Hathaway offered to buy out the fund's partners. This offer was however discarded and the same day the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors which include Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, JPMorgan, Morgan Stanley, Salomon Smith Barney, UBS etc. There was an abnormal decline in the stock prices of banks and financial institutions that were a part of the bailout. Stock prices of financial institutions participating in the bailout dropped by over 21% from the time of LTCMs announcement of losses through the bailout period (Jill L.Wetmore, 2007).
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Contagion usually refers to the transmission of a crisis from one market/economy to others, and has been an important feature in past financial crisis episodes (Cheung, Tam et al, 2009). It is remarkable to see from the past financial crisis, how swiftly shocks are transferred from one system to another or probably to markets around the financial world. On the days soon after the announcement of LTCM took place on September 2, banks participating in the bailout or exposed to LTCM in one way or the order showed significant abnormal returns. The results of this study also show that non-exposed banks also experienced negative abnormal returns on the days following the loss announcement, which clearly shows the contagious effect of the near collapse of LTCM. In fact all the ten banks (exposed and non-exposed) included in this study showed abnormal negative returns on the immediate day after the loss announcement. The four banks in the DataStream retail banking index for the U.S. that attended the meeting at the Federal Reserve Bank of New York had an abnormal return of 10.93% (Kho, Lee and Stulz, 1999). During the same period, the banks that were not a part of the bailout or had no exposure to LTCM also experienced abnormal returns. Although the banks exposed to LTCM notably underperformed than the ones not exposed to it but still there was a clear evidence of contagion.

This particular study includes five banks that participated in the bailout or had exposure to LTCM which can be either loan exposure or capital exposure. These include Citicorp (loan exposure), JP Morgan Chase (bailout), Morgan Stanley (bailout), Lehman Brothers (bailout) and Bank of America (loan exposure). The banks considered in the study are strictly U.S. banks (both investment and commercial). This study also includes five U.S. banks which had no exposure to LTCM in any way. These include ASSD BANCORP, Comerica, BB&T, Wells Fargo & Co and Huntington.

The study compares the abnormal returns of U.S. commercial banks to those of investment banks that were a part of the bailout around few important dates. The losses experienced by investment banks were greater than those of commercial banks during the bailout phase. The sample of banks with no exposure to LTCM is taken in order to show the contagion effect of the crisis.

LTCM was the biggest disaster of its kind and hence there is a need to test the effects on systemic risk. It refers to the risks imposed by inter linkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market (Steven L. Schwarcz, 2008). We expect risk to rise during the crisis and eventually fall with the rescue organised by the Federal Bank. Hence, systemic risk is expected to be significantly lower after the crisis.

REVIEW OF LITERATURE

Telfah, Hassan and kilic (2001) examined the effect of the LTCM debacle on the financial institutions using an EARCH (1,1) model. Their study revealed that all financial institutions reacted negatively to the crisis but banks were affected the most out of all financial institutions. The study also gave credit to the Fed bailout for curtailing the effects of the crisis and then restricting the volatility soar after the near collapse of the fund.

Kho, Lee and Stultz (2000) examined the effect of the LTCM collapse on U.S. commercial bank returns. Investment banks and foreign banks were kept out from this study. The event study laid stress on the days surrounding September 2 and showed how exposed banks underperformed
7

compared to non-exposed banks. The results advocate that the market was clearly capable of distinguishing between exposed and unexposed banks. Due to lack of information, this particular study defined exposed banks as those who were a part of the bailout of the fund.

Jorion (2000) analyzed the risk profile and strategies of LTCM using Value at Risk framework. A major reason for the collapse is attributed to its underestimation of risk by the management. LTCMs risk profile relied mostly on short term history and past data to predict future price movements under normal market conditions. Further, using same covariance matrix to estimate risk has been biased in case of LTCM hedge fund.

Furfine (2001) examined 164 lending and borrowing banks and nine commercial banks participating in the bailout. The results clearly show that creditor banks reduced their borrowing during the crisis but did not change their level of borrowing after the bailout while other large banks were reducing their borrowing considerably. The results clearly show that the creditor banks were not in danger of default.

Kabir and Hassan (2005) examined contagion with respect to LTCM crisis. Their sample includes U.S. financial institutions including commercial banks, investment banks and insurance companies. Non U.S. financial institutions are excluded from their study. Their results show that both commercial and investment banks showed abnormal negative returns but losses accruing to investment banks were larger than those of commercial bank. Evidence of contagion and toobig-to-fail effect were also found.

Jill L.Wetmore (2007) included thirteen of the fourteen banks that took part in the bailout. Non U.S. banks were included for the first time. This was the largest number of banks included in one single study. The results show that banks with no exposure to LTCM outperformed banks with exposure to LTCM. The study also showed evidence of contagion when unexposed banks also showed abnormal negative returns. U.S. banks participating in the bailout show less insurance effect as compared to non U.S. banks which were also a part of the bailout. Since non U.S. banks were included for the very first time, adjustments in methodology had to be made with respect to time, foreign exchange and financial market.

Mardi, Renee, Gonzalez and Martin (2002) examined the contagion effect on the international bond market during the Russian and LTCM crisis. This paper studies the increase in financial volatility in both emerging and advanced economies during this period. The contagion effect of Russian crisis and LTCM debacle is explained by focussing on long term sovereign bonds issued by growing economies and long term corporate bonds issued in advanced economies. These spreads reached exceptionally high levels in both developing and developed economies.

Mete Feridun (2005) analysed the failure of LTCM hedge fund from a risk management point of view. The study suggests that out of many reasons for the collapse, failure of the Value at risk system can be attributed as a major cause. The system adopted by the management failed in its task to estimate the funds risk exposure. LTCM used different combination of VaR techniques which heavily relied on past data and information to predict future price movements. The unexpected events that took place in 1998 (Russian crisis) was beyond the scope of the VaR models and hence resulted in serious underestimation of daily losses.

Siddharth Prabhu (2001) analysed the dangers of high leverage from LTCM point of view. The paper also explains the role of regulations. The unregulated nature of hedge funds means very little is known about their activities. There has also been unprecedented growth in the number of unregulated hedge funds in the past decade or so. LTCM had an astounding leverage level of 30 to 1 which was way above the normal level. Such a high leverage level meant that one third of the fund dont borrow and even on the remaining funds, very few borrow at a level greater than 10 to 1. Hence, high level of leverage caused the liquidation pressure on the fund which contributed towards its near collapse.

Roger Lowenstein (2000) wrote the famous book When Genius Failed: The Rise and Fall of LongTerm Capital Management. The book published by Random House in 2000 received numerous awards including being chosen by Business week as one of the best business books of 2000. The book deals with the rise and fall of LTCM in 1998. The strategies adopted, downturn, bailout and lessons learnt from the event were all covered in the book.

Franklin R.Edwards (1999) in his paper Hedge funds and collapse of Long Term Capital Management took upon the task to explain legal and organisational structure of hedge funds and the policy implications of the near collapse of Long Term Capital Management. The paper sheds light on the mistakes committed by the management, role of the Fed and the regulatory and policy changes that took place after the debacle. The message of this collapse was loud and clear, the risk management techniques of US banks and other financial institutions is not what it actually should be. This crisis acted as a wake-up call for many banks in the US and all over the globe to revive and renew their risk management techniques.

10

The study also suggests more regulations on hedge funds such as more disclosure, limits on leverage etc in order to make sure that another LTCM never happens.

DATA AND METHODOLOGY

a.1) MAIN MODEL

Rather than using an event study model, we use a multivariate regression model (MVRM) given by Cornett and Tehranian (1990). This model is based on Seemingly Unrelated Regression (Zellner, 1962 and Kho et al, 1999). Such a model uses event clustering to adjust for an increase in variance of abnormal returns. The equation given below is estimated over a 252 trading day period (January 1 to December 31, 1998). The following models are estimated for the excess returns of the equally -weighted U.S. bank portfolios and individual U.S. banks included in this study.

Rpt = c0 +

Rmt +

....(1)

Where, Rpt is the logarithmic daily return. Rmt is the Datastream U.S. stock market index return Xt includes the trade weighted exchange rate and the change in the Federal Fund rate. is a dummy variable taking a value of 1 for the j-th event day or zero otherwise. Dj represents an abnormal return for the j-th event date.

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a.2) SYSTEMIC RISK EFFECTS

In order to test for the systemic risk, we take the following regression system with dummy variables for LTCM crisis period and the after crisis phase (Kabir and Hassan, 2005). We consider three different portfolios of banks ( All banks, exposed banks and non-exposed banks) for both the periods mentioned above.

Rit=( i + i,criDcri + i,aftDaft) + (i + i,criDcri + i,aftDaft)Rmt + ifedt + Ext + et

...(2)

Where, Dcri is a dummy for the LTCM crisis period. Daft is a dummy for the aftermath period. j is the systemic risk of a portfolio. j,cri and j,aft are risks of a portfolio of banks during and after the crisis.

Therefore, (j+ j,cri ) and (j+ j,aft) are the incremental risk of a portfolio during and after the LTCM debacle respectively. We expect a rise in the risk of all portfolios during the crisis period and a decline in the aftermath phase.

b) EVENT SELECTION LTCM was a hedge fund and for this reason publicly available information was not available to its investors. As a result, news of the collapse was not known until a few days before the crisis. The management officially declared losses on September 2, 1998. With the initiation of Federal
12

Reserve Bank of New York and 14 other exposed banks, bailout was announced on September 23, 1998. The media reported this news of the bailout by a consortium of 14 banks the following day, September 24, 1998. We select the dates surrounding September 2, 1998 and key dates around the bailout period. While testing for systemic risk, each portfolio of banks is estimated for the crisis period (September 2 to 24, 1998) and post crisis period (September 25 to October 14, 1998).

c)

DATA COLLECTION

Daily stock price data for the exposed banks is gathered from Datastream. For comparison, the data for non-exposed banks is also collected from the same source. Federal fund rate is also collected from the same source. The daily trade weighted exchange rate data is extracted from the Board of Governors of the Federal Reserve System. Table 1: List of Commercial and Investment banks included in the study.
Name of Financial Abbreviation Relationship crisis to LTCM

Institution

Citigroup JP Morgan Morgan Stanley Lehman Brothers Bank of America ASSD Bancorp

CG JPM MS LB BoA ABC

Loan Exposure Bailout Bailout Bailout Loan Exposure Non-exposed

13

Comerica BB&T Wells Fargo & co Huntington

Com BBT WF Hun

Non-exposed Non-exposed Non-exposed Non-exposed

As can be seen, three of fourteen banks who participated in the bailout are included. Two banks with loan relationship with LTCM but were not a part of the bailout are also included. Overall five banks exposed to LTCM are included. Five banks with no relation to LTCM are used for the purpose of comparison and to establish contagion effect.

d)

METHODOLOGY

Abnormal returns cannot be calculated using the traditional event study methodology as clustering is a major problem when events affect a single industry. Therefore abnormal returns are calculated using Seemingly Unrelated Regressions. This system of Seemingly Unrelated Regressions takes into account heteroskedasticity across equations and contemporaneous correlation between disturbances (Hassan & Kabir, 2005). A traditional event study model which gives us biased estimates of abnormal returns, since the returns of firms of the same industry calculated over the same time period are usually correlated. Moreover, MVRM makes an assumption that disturbance variances differ across equations. Hence, explaining the growing significance and popularity of Multivariate Regression Model over the usual event study model.

We have a contracted event window as other events which may affect our results occur close to our event period. The Russian default occurred just before and the Brazilian crisis occurred just after the LTCM debacle. Hence a narrow event window moderates the effects of this problem.
14

We construct portfolios of exposed and non-exposed banks. Exposed banks show positive exposure to the LTCM crisis. Moreover, a bank which had loan or capital exposure to LTCM and not essentially was a part of the bailout clan might also have been affected by the crisis because of its attempt to imitate LTCMs position. Proof of contagion is shown by significant abnormal returns by banks with no relation to LTCM. Less difference between the loss of market value of exposed and non-exposed banks gives us a clear indication of contagion.

In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system (George G. Kaufman [World Bank]). A systemic risk should affect all banks irrespective of their size and market. Therefore, we take equally weighted portfolios of banks to accurately guess the impact of events on systemic risk. Incremental risk is higher during the crisis period but is expected to reduce after the crisis (Kabir and Hassan, 2005).

There may also have been successful predictions regarding the increase in risk of LTCM and its effect on associated firms which would make a vigilant analyst sell stocks of firms tied to LTCM before the big announcement of September 2, 1998. Therefore, a successful anticipation of loss prior to an official announcement might be a cause of results not being statistically significant.

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EMPIRICAL RESULTS

The results of this study are generally consistent with other authors Kho, Lee et al (2000) and Kabir and Hassan (2005) suggesting sturdiness of the model used. Table 2 gives the results of changes in stock prices of all the banks included in this study (exposed and non-exposed). For comparison, returns on the S&P 500 are also shown.

Table 2. Change in stock prices of banks during LTCM cricis (%) NON-EXPOSED BANKS Bank/Dates ABC Com BBT WF Hun 1/9 - 25/9 6.10 2.81 11.80 18.94 6.65

BoA -2.28

EXPOSED BANKS CG JPM MS -7.20 -17.08 -8.67

LB -16.08

The group of banks exposed to LTCM show lower returns than the ones not exposed to LTCM. Financial institutions with loan or investment exposure (Citigroup and Bank of America) performed better than the ones participating in the bailout. The banks with no exposure to LTCM had positive returns during the period September 1 to 25, 1998 and hence, outperformed the banks with relationship to the LTCM near collapse. Table 3 gives the results of the event study. We include equally weighted portfolios of banks. We divide our ten banks into two separate groups. Exposed banks make one group whereas nonexposed banks form the other. The results are also shown for individual banks later in Table 4. The event study periods are shown for the period 1-3 September and 23-25 September. We work around the dates surrounding the all important date September 2, 1998. We consider a day before the official announcement to check for leakage of information. The dates 23-25 September are significant to show the effects of the intervention of Federal Bank of New York

16

and the bailout that followed. The initial announcement of the troubles faced by LTCM occurred in mid July but no group or bank shows any abnormal returns during that period as indicated by other authors like Kabir and Hassan (2005). Hence, it is not taken as an event date in this study.

Table 3. Abnormal returns of the equally-weighted U.S. bank portfolios on certain event dates (see appendix Section.1). Group 1: Equally Weighted of all the banks. (N=10) Group 2: Equally Weighted of banks with exposures to LTCM. (N=5) Group 3: Equally Weighted of banks with no exposure to LTCM. (N=5)

Group 1 Intercept US market return

Federal change Fund rate

Group 2 0.053 ( 0.043) 1.609 (0.079) 0.004 (0.004)

Group 3 0.030 (0.025) 1.128 (0.047) -0.001 (0.002)

0.042 (0.026) 1.368 (0.051) 0.001 ( 0.002)

Exchange rate 01/09/1998 02/09/1998 03/09/1998 23/09/1998 24/09/1998 25/09/1998

-0.0003 (0.0002) -2.283 (0.010) 1.807 (0.009) -2.880 (0.009) 0.870 (0.009) -2.172 (0.009) 0.789 (0.009)

-0.0005 (0.0004) -5.672 (0.015) 2.829 (0.015) -5.212 (0.015) 2.569 (0.015) -4.708 (0.015) 1.244 (0.015)

-0.0003 (0.0002) 1.093 (0.009) 0.788 (0.009) -0.548 (0.009) -0.827 (0.009) 0.363 (0.009) 0.333 (0.009)

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According to Table 3, banks with no exposure to LTCM in any way show no significant negative abnormal return over the event dates studied except for September 3, 1998. On the other hand, exposed banks underperformed during key event dates surrounding the official announcement on September 3, 1998 and during the bailout phase as well. This abnormal negative return of non-exposed banks can be caused due to the fact that some of the non-exposed banks were aware of the positions held by LTCM and could have taken up similar positions or an attempt to be a part of the bailout can be a reason for negative returns on September, 1998. In this case contagion cannot be completely ruled out and can be a reason never the less. This clearly shows that exposed banks are more affected by the event than the non-exposed banks and market successfully differentiates between exposed and non-exposed banks (Kho, Lee et al, 1999).

Table 4: Abnormal returns of the ten individual U.S. banks exposed and non-exposed to the LTCM crisis at the time of the loss announcement and bailout period(see appendix section.2).

Name

01/09/1998

02/09/1998

03/09/1998

23/09/1998

24/09/1998

25/09/1998

CG JPM MS BoA LB ABC Com BBT WF Hun

-0.084* -0.011 -0.078* -0.054* -0.153* -0.007 0.017 -0.001 -0.009 0.057*

0.034 0.008 0.032 0.030 -0.095** -0.003 0.030** 0.011 0.016 -0.015

-0.062* -0.094 -0.078* -0.011 -0.143* -0.010 -0.004 -0.003 -0.001 -0.005

0.028 0.030 -0.001 0.030*** -0.109* -0.034*** -0.017 0.031* -0.006 -0.014

-0.041*** -0.044** -0.062* -0.044** -0.086** 0.003 -0.002 0.013 0.007 -0.006

0.012 -0.022 0.014 0.028 0.008 0.007 -0.018 -0.014 0.011 0.026***

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* is significant at 1% level.

** is significant at 5% level.

*** is significant at 10% level.

Table 4 clearly suggests that banks with no exposure to LTCM outperformed the banks exposed to LTCM. The non-exposed banks show very low negative return on the dates surrounding the official announcement of losses by the LTCM management. These banks show higher returns than the exposed banks on September 2 and 24 as well as for the other event dates. This clearly suggests that market differentiates between exposed and non-exposed banks. Exposed banks are more badly hit by events than the non-exposed ones.

The results in Table 4 also show significant negative abnormal returns for banks and financial institutions with loan exposure to LTCM but were not a part of the bailout. Citigroup and Bank of America (loan exposure) show negative abnormal returns on September 1, 3 and 24. These results clearly shows that market differentiates and can pick out banks with any relation to the crisis. These banks are clearly hit by the crisis but suffer less than the banks participating in the bailout process.

As mentioned above, the banks participating in the bailout (Morgan Stanley, JP Morgan & Chase and Lehman Brothers) show high negative abnormal returns on September 1, 3 and 24. The high negative abnormal returns of these three banks compared to other banks in the study clearly indicate the high level of risk due to high exposure to LTCM.

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The results of table 4 further show that when we take a look at individual results for September 1 shows that eight out of the ten banks show negative abnormal returns. On the day after the official announcement of the losses, all banks included in this study (both exposed and nonexposed) experienced negative abnormal returns. This clearly shows the importance of dates around the formal announcement of the losses by the management of the fund. Abnormal negative returns of banks with no exposure to LTCM around important event dates like September 1, 3 and 23 show clear signs of contagion. Three out of the five banks considered for this study show negative abnormal returns on these key event dates. The massive size and leverage positions of LTCM with other banks along with its failure to disclose information made sure that the impact went beyond exposed banks resulting in a contagious effect on the U.S. banking sector. Another reason why these non-exposed banks suddenly show negative returns on these dates can be due to the possibility of leakage of information about LTCMs actual positions and these banks tried to take up similar positions. Sudden negative returns on

September 23 may be due to their efforts to participate in the bailout process. But Contagion is also a big possibility as suggested by other authors like Kabir and Hassan (2005).

Among the exposed banks, Bank of America being a commercial bank outperformed other investment banks in the group. Bank of America did fairly well on September 3, 23, 24 and 25 as compared to the investment banks in the same group. This clearly shows that investment banks were more badly affected by this crisis and were supposed to be in greater danger as perceived by the market. This result again is in accordance to the findings of other authors.

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Impact on systemic risk

The results in this segment are based on equation (2) and are shown in Table 5. The systemic risk of the three portfolios considered (All banks, exposed banks and non-exposed banks) during and after the LTCM crisis is given by (+cri) and (+aft) respectively. Where, represents the incremental risk during and after the crisis. With the help of Wald test we can also conclude that the systemic risk of all three portfolios is significant.

Table 5. Results of the systemic portfolio risk (see appendix section.3).

Portfolios All banks Exposed banks Non-exposed banks

0.056** 0.075*** 0.0366

cri -0.004*** -0.011* 0.002

aft -0.001 -0.001 -0.0004

* is significant at 1% level.

** is significant at 5% level.

*** is significant at 10% level.

Portfolio All banks Exposed banks Non-exposed banks

during crisis (+cri) 1.677 2.113 1.238

after crisis (+aft) 1.623 1.834 1.412

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Sensitivity of each portfolio considered here is estimated for crisis phase (September 2 to September 24, 1998) and post crisis period (September 25 to October 14, 1998) by regressing equation (2) in a Seemingly Unrelated Regression (SUR) structure. The systemic risk of all three portfolios is highly significant (see appendix section.3). We can conclude from the above table that risks have been considerably in the aftermath of LTCM crisis except for the portfolio of nonexposed banks. We expected incremental risk to rise during the crisis and with the rescue and the bailout process initiated by the Federal Bank the risk gradually decreased. Even though many funds are now much larger than LTCM, which collapsed in 1998 and received a $3.5 billion bailout to avoid widespread financial disorder, dont have the power to affect the global financial system the way LTCM did. Hans Hufschmid, currently chief executive at fund servicing firm GlobeOp, said brokers are the reason, who now act as an effective brake on hedge fund risk (Winchester, 2009).

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CONCLUSION The enormous size of LTCM as a hedge fund and its leverage positions with other small and big banks in the U.S. made sure that the collapse of LTCM would create ripples in the American financial industry. LTCM was thought to be the ultimate hedge fund but bad bets, lack of risk management and various other factors contributed towards it downfall. The bailout by the Federal Bank, while other options were still available, also came under scrutiny as it gave incentive to other banks to undertake risky ventures in the future. Being a hedge fund, LTCM failed to disclose its positions and key information to its investors and the outside world. This made sure that a collapse of the fund would not only affect banks exposed to LTCM but will have a contagious effect on banks which had nothing to do with the fund. The results of this study show that banks with no exposure outperform banks exposed to LTCM. Similarly, banks with loan or capital exposure outperform banks that were a part of the bailout. This clearly shows the ability of the market to differentiate between exposed and nonexposed banks. The banks exposed to the crisis lost a considerable amount of their market value during the key event dates surrounding the official announcement and the bailout, but the losses pertaining to the investment banks were higher than those of commercial banks. The only exposed commercial bank (Bank of America) considered in this study shows negative return on key event dates but outperformed investment banks included in the study. The crisis in short had its adverse affects on both exposed and non-exposed banks. Both portfolio of banks experienced loss in their market value. Thus our results show contagion effect of the near-collapse on the U.S. financial sector during the near collapse of LTCM.
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Another important conclusion deals with the impact on systemic risk. We find significant systemic risk for all three bank portfolios included in the study. As expected incremental risk was high during the crisis period but reduced considerably after the crisis except for the non-exposed banks, they are still higher compared to the crisis period. The results of this study are in accordance to the results of other authors.

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BIBLIOGRAPHY

C.Furfine. (2001). The Cost and Benefits of Moral Suasion: Evidence from the rescue of LTCM. Cheung, T. a. (2009). Contagion of Financial Crises: A literature review of theoretical and empirical framework.

Cornett and Tehranian, 1990. M.M. Cornett and H. Tehranian, An examination of the impact of the Garn-St. Germain Depository Institutions Act of 1982 on commercial banks and savings and loans. J. Finance (1990), pp. 95112. Full Text via CrossRef

Dowd, K. (1999). Too Big To Fail? LTCM and the Federal Reserve. CATO Institute Briefing Papers , 1-12.

Dungey, F. H. (2002). Contagion in International Bond markets during the Russian and LTCM crises. Edwards, F. R. (2003). The Regulation of Hedge Funds: Financial Stability and investors protection. Frankfurt. F.R.Edwards. (1999). Hedge Funds and the collapse of LTCM. Feridun, M. (2005). Value at Risk: Lessons from the crash of LTCM . Journal of Business Administration online. Vol.4 No.1 .

Greenspan, A., (1998). Private-Sector Refinancing of the Large Hedge Fund, Long-Term Capital Management. Testimony of Chairman Alan Greenspan.
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Hassan, K., & Kabir, H. (2005). The Near-collapse of LTCM, US Financial Stock Returns, and The Fed. Journal of Banking and Finance, Vol. 29, Issue 2 , 441-60. Haubrich, Joseph G.(2007) ,Some Lessons on the Rescue of Long-Term Capital Management. I.Swary. (1986). Stock market reaction to regulatory action in the continental Illinois crisis. Journal of Business , 451-473. James, C. (1991). The losses realised in Bnk failures. Journal of Finance , 1223-1242. Jorion, P. (1999). Risk Management Lessons from Long Term Capital management.

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Kho, L. a. (December, 1999). U.S. BANKS, CRISES AND BAILOUTS: FROM MEXICO TO LTCM.

Kolman, J. (1999, April). LTCM Speaks. Retrieved August 2009, from Derivativesstrategy.com. Lang, L.H.P, & Stulz. (1992). Contagion and intra-industry effects of bankruptcy announcements. Journal of Financial Economics .

MACKENZIE, D., (2000). Long-Term Capital Management and the Sociology of Finance. The London Review of Books.

Madura, J., & McDaniel. (1989). Market reaction to increased loan loss reserves at money center banks. Journal of Financial Services Research , 359-370. Management(LTCM) and its bailout effects on US Financial Institutions. Paper presented at the Financial Management Conference, Toronto.
26

P.Jorion. (2000). Risk Management Lessons from Long Term Capital Management. P.Stonham. (1999). Too Close to the Hedge: The case of LTCM . Prabhu, S. (2001, May). LTCM: The Dangers of Leverage. Durham, NC. R.Lowenstein. (2000). When Genius Failed. New York: Random House. Shirreff, d. Lessons from the collapse of hedge fund, Long Term Capital Management. Thompson, & Lamy, R. (1986). Penn square, problem loans and insolvency risk. Journal of Financial Risk , 100-112. Wetmore, J. L. (2007). LTCM revisited: Accommodations for International Markets. Global Journal of finance and Banking, Vol.1 . Winchester, R. (2009, March). No hedge fund now poses systemic risk: LTCM partner . Y.Leitner. (2002). A Life line for the Weakest Link? Financial Contagion and Network. Business Review-Federal Reserve Bank of Philadelphia , pp. (fourth quarter) pp.18-24. Zellner, A. (1962). An Effecient method of estimating Seemingly Unrelated regression. Journal of American Statistical Association , 348-370.

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APPENDIX

Section.1: Abnormal returns of the equally-weighted U.S. bank portfolios on key event dates (

September 1, 2, 3, 23, 24 and 25, 1998).

1.1) All Banks (group 1) Dependent Variable: ALL Method: Least Squares Date: 08/27/09 Time: 03:03 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.042286 1.368851 0.001362 -0.000438 -0.022835 0.018087 -0.028803 0.008709 -0.021725 0.007890 Std. Error 0.027692 0.051563 0.002697 0.000281 0.010012 0.009821 0.009796 0.009954 0.009859 0.009787 t-Statistic 1.526984 26.54690 0.505178 -1.558083 -2.280780 1.841716 -2.940254 0.874937 -2.203682 0.806208 Prob. 0.1281 0.0000 0.6139 0.1205 0.0234 0.0667 0.0036 0.3825 0.0285 0.4209

1.2) Exposed Banks(group 2)

Dependent Variable: ALL_EX Method: Least Squares Date: 08/27/09 Time: 03:04 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.053636 1.609038 0.004476 -0.000551 -0.056603 0.028293 -0.052124 0.025692 -0.047085 0.012449 Std. Error 0.042875 0.079833 0.004175 0.000435 0.015501 0.015205 0.015167 0.015411 0.015264 0.015153 t-Statistic 1.251004 20.15515 1.071956 -1.266406 -3.651678 1.860762 -3.436743 1.667184 -3.084817 0.821585 Prob. 0.2121 0.0000 0.2848 0.2066 0.0003 0.0640 0.0007 0.0968 0.0023 0.4121

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1.3) Non-Exposed Banks(group 3)

Dependent Variable: ALL_NEX Method: Least Squares Date: 08/27/09 Time: 03:04 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.030936 1.128664 -0.001751 -0.000325 0.010934 0.007881 -0.005482 -0.008275 0.003635 0.003331 Std. Error 0.025652 0.047765 0.002498 0.000260 0.009274 0.009097 0.009074 0.009220 0.009132 0.009066 t-Statistic 1.205980 23.62958 -0.700967 -1.247384 1.178984 0.866329 -0.604073 -0.897487 0.397997 0.367437 Prob. 0.2290 0.0000 0.4840 0.2135 0.2396 0.3872 0.5464 0.3704 0.6910 0.7136

Section.2: Abnormal returns of the ten individual U.S. banks exposed and non-exposed to the LTCM crisis at the time of the loss announcement and bailout period.
Citi group
Dependent Variable: CG Method: Least Squares Date: 08/27/09 Time: 03:24 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.043829 1.719204 0.002018 -0.000458 -0.085412 0.034880 -0.062765 0.028056 -0.040950 0.013202 Std. Error 0.062996 0.117300 0.006135 0.000640 0.022775 0.022341 0.022285 0.022643 0.022427 0.022264 t-Statistic 0.695735 14.65650 0.328914 -0.716049 -3.750180 1.561273 -2.816507 1.239030 -1.825902 0.592967 Prob. 0.4873 0.0000 0.7425 0.4747 0.0002 0.1198 0.0053 0.2165 0.0691 0.5538

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JP Morgan
Dependent Variable: JPM Method: Least Squares Date: 08/27/09 Time: 03:04 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.116702 1.514325 8.85E-05 -0.001183 -0.010793 0.008201 -0.094300 0.030858 -0.044796 -0.022867 Std. Error 0.054589 0.101645 0.005316 0.000554 0.019736 0.019359 0.019311 0.019621 0.019434 0.019293 t-Statistic 2.137820 14.89813 0.016648 -2.134856 -0.546881 0.423613 -4.883305 1.572667 -2.305045 -1.185280 Prob. 0.0335 0.0000 0.9867 0.0338 0.5850 0.6722 0.0000 0.1171 0.0220 0.2371

Morgan Stanley
Dependent Variable: MS Method: Least Squares Date: 08/27/09 Time: 03:04 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.080102 1.946626 0.020239 -0.000814 -0.076703 0.037338 -0.078072 -0.001613 -0.060428 0.014433 Std. Error 0.064887 0.120820 0.006319 0.000659 0.023459 0.023011 0.022954 0.023323 0.023100 0.022932 t-Statistic 1.234477 16.11175 3.202974 -1.235858 -3.269639 1.622584 -3.401292 -0.069150 -2.615891 0.629382 Prob. 0.2182 0.0000 0.0015 0.2177 0.0012 0.1060 0.0008 0.9449 0.0095 0.5297

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Bank of America
Dependent Variable: BOA Method: Least Squares Date: 08/27/09 Time: 03:04 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.013876 1.432551 1.43E-06 -0.000152 -0.055122 0.030548 -0.012753 0.035566 -0.044650 0.028779 Std. Error 0.055636 0.103594 0.005418 0.000565 0.020114 0.019731 0.019681 0.019997 0.019807 0.019663 t-Statistic 0.249409 13.82852 0.000263 -0.268263 -2.740416 1.548273 -0.648009 1.778516 -2.254307 1.463643 Prob. 0.8033 0.0000 0.9998 0.7887 0.0066 0.1229 0.5176 0.0766 0.0251 0.1446

Lehman Brothers
Dependent Variable: LB Method: Least Squares Date: 08/27/09 Time: 03:04 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.105934 0.549787 -0.003916 -0.001062 -0.154741 -0.096715 -0.144287 -0.109270 -0.086407 0.008372 Std. Error 0.110697 0.206118 0.010780 0.001124 0.040021 0.039257 0.039159 0.039788 0.039409 0.039122 t-Statistic 0.956977 2.667344 -0.363277 -0.944868 -3.866511 -2.463619 -3.684687 -2.746293 -2.192594 0.214009 Prob. 0.3395 0.0082 0.7167 0.3457 0.0001 0.0145 0.0003 0.0065 0.0293 0.8307

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ASSD Bancorp
Dependent Variable: ABC Method: Least Squares Date: 08/27/09 Time: 03:03 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.038897 0.854726 -0.008330 -0.000412 -0.007761 -0.003665 -0.010185 -0.034116 0.003816 0.007772 Std. Error 0.052142 0.097089 0.005078 0.000529 0.018851 0.018492 0.018445 0.018742 0.018563 0.018428 t-Statistic 0.745984 8.803566 -1.640582 -0.778809 -0.411724 -0.198189 -0.552173 -1.820314 0.205555 0.421730 Prob. 0.4564 0.0000 0.1022 0.4369 0.6809 0.8431 0.5813 0.0699 0.8373 0.6736

Comerica
Dependent Variable: COM Method: Least Squares Date: 08/27/09 Time: 03:04 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.037126 1.193214 -0.000547 -0.000383 0.016463 0.030405 -0.005596 -0.017359 -0.001778 -0.017044 Std. Error 0.038497 0.071681 0.003749 0.000391 0.013918 0.013652 0.013618 0.013837 0.013705 0.013605 t-Statistic 0.964401 16.64609 -0.145814 -0.980985 1.182867 2.227053 -0.410909 -1.254508 -0.129727 -1.252766 Prob. 0.3358 0.0000 0.8842 0.3276 0.2380 0.0269 0.6815 0.2109 0.8969 0.2115

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BB&T
Dependent Variable: BBT Method: Least Squares Date: 08/27/09 Time: 03:04 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.044636 1.054443 0.001969 -0.000456 -0.001238 0.012115 -0.003313 0.031781 0.014102 -0.013711 Std. Error 0.032206 0.059968 0.003136 0.000327 0.011644 0.011422 0.011393 0.011576 0.011466 0.011382 t-Statistic 1.385930 17.58330 0.627961 -1.394265 -0.106350 1.060721 -0.290764 2.745375 1.229967 -1.204586 Prob. 0.1670 0.0000 0.5306 0.1645 0.9154 0.2899 0.7715 0.0065 0.2199 0.2295

Wells Fargo & Co

Dependent Variable: WF Method: Least Squares Date: 08/27/09 Time: 03:05 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient 0.050781 1.118544 0.000326 -0.000523 -0.009463 0.016334 -0.001529 -0.006766 0.008191 0.012065 Std. Error 0.046360 0.086322 0.004515 0.000471 0.016761 0.016441 0.016400 0.016663 0.016504 0.016384 t-Statistic 1.095373 12.95781 0.072254 -1.111724 -0.564596 0.993484 -0.093216 -0.406047 0.496303 0.736358 Prob. 0.2744 0.0000 0.9425 0.2674 0.5729 0.3215 0.9258 0.6851 0.6201 0.4622

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Huntington
Dependent Variable: HUN Method: Least Squares Date: 08/27/09 Time: 03:04 Sample: 1 252 Included observations: 252 Variable C SP500 FED EXC D901 D902 D903 D923 D924 D925 Coefficient -0.016968 1.422265 -0.002177 0.000153 0.056592 -0.015843 -0.006824 -0.014908 -0.006219 0.027548 Std. Error 0.044009 0.081944 0.004286 0.000447 0.015911 0.015607 0.015568 0.015818 0.015667 0.015553 t-Statistic -0.385553 17.35647 -0.507976 0.341601 3.556864 -1.015111 -0.438345 -0.942452 -0.396972 1.771191 Prob. 0.7002 0.0000 0.6119 0.7329 0.0005 0.3111 0.6615 0.3469 0.6917 0.0778

Section.3: Results of the systemic portfolio risk. 3.1) Portfolio of All Banks
Dependent Variable: ALL Method: Least Squares Date: 08/27/09 Time: 03:05 Sample: 1 252 Included observations: 252 Variable C DCRI DAF SP500 SP500_DCRI SP500_DAF EXC FED Coefficient 0.056220 -0.004673 -0.001051 1.263806 0.413373 0.360470 -0.000577 0.000895 Std. Error 0.028580 0.002586 0.002958 0.058880 0.130942 0.181381 0.000290 0.002750 t-Statistic 1.967140 -1.806746 -0.355193 21.46418 3.156923 1.987361 -1.990085 0.325317 Prob. 0.0503 0.0720 0.7228 0.0000 0.0018 0.0480 0.0477 0.7452

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Significant systemic risk of All banks portfolio (Wald Test)

During crisis period Wald Test: Equation: SYS_ALL Test Statistic F-statistic Chi-square Value 335.6271 671.2541 df (2, 244) 2 Probability 0.0000 0.0000

Null Hypothesis Summary: Normalized Restriction (= 0) C(4) C(5) Value 1.263806 0.413373 Std. Err. 0.058880 0.130942

After crisis period

Wald Test: Equation: SYS_ALL Test Statistic F-statistic Chi-square Value 269.9440 539.8880 df (2, 244) 2 Probability 0.0000 0.0000

Null Hypothesis Summary: Normalized Restriction (= 0) C(4) C(6) Value 1.263806 0.360470 Std. Err. 0.058880 0.181381

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3.2) Portfolio of All Exposed Banks

Dependent Variable: ALL_EX Method: Least Squares Date: 08/27/09 Time: 23:49 Sample: 1 252 Included observations: 252 Variable C DCRI DAF SP500 SP500_DCRI SP500_DAF EXC FED Coefficient 0.075758 -0.011929 -0.001621 1.464767 0.649980 0.370732 -0.000770 0.003798 Std. Error 0.045582 0.004125 0.004718 0.093907 0.208839 0.289285 0.000462 0.004387 t-Statistic 1.662010 -2.891877 -0.343487 15.59800 3.112347 1.281542 -1.666430 0.865742 Prob. 0.0978 0.0042 0.7315 0.0000 0.0021 0.2012 0.0969 0.3875

Significant systemic risk of All Exposed banks portfolio (Wald Test)

During crisis period Wald Test: Equation: SYS_ALL_EX Test Statistic F-statistic Chi-square Value 187.3520 374.7041 df (2, 244) 2 Probability 0.0000 0.0000

Null Hypothesis Summary: Normalized Restriction (= 0) C(4) C(5) Value 1.464767 0.649980 Std. Err. 0.093907 0.208839

After crisis period

Wald Test: Equation: SYS_ALL_EX Test Statistic F-statistic Chi-square Value 141.4660 282.9321 df (2, 244) 2 Probability 0.0000 0.0000

Null Hypothesis Summary: Normalized Restriction (= 0) C(4) C(6) Value 1.464767 0.370732 Std. Err. 0.093907 0.289285

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3.3) Portfolio of All Nom-Exposed Banks

Dependent Variable: ALL_NEX Method: Least Squares Date: 08/27/09 Time: 23:49 Sample: 1 252 Included observations: 252 Variable C DCRI DAF SP500 SP500_DCRI SP500_DAF EXC FED Coefficient 0.036684 0.002583 -0.000481 1.062843 0.176765 0.350201 -0.000383 -0.002008 Std. Error 0.025781 0.002333 0.002668 0.053114 0.118119 0.163619 0.000261 0.002481 t-Statistic 1.422907 1.107234 -0.180253 20.01066 1.496497 2.140338 -1.465962 -0.809450 Prob. 0.1560 0.2693 0.8571 0.0000 0.1358 0.0333 0.1439 0.4190

Significant systemic risk of All Non-Exposed banks portfolio (Wald Test)

During crisis period Wald Test: Equation: SYS_ALL_NEX Test Statistic F-statistic Chi-square Value 271.0540 542.1081 df (2, 244) 2 Probability 0.0000 0.0000

Null Hypothesis Summary: Normalized Restriction (= 0) C(4) C(5) Value 1.062843 0.176765 Std. Err. 0.053114 0.118119

After crisis period

Wald Test: Equation: SYS_ALL_NEX Test Statistic F-statistic Chi-square Value 237.1697 474.3393 df (2, 244) 2 Probability 0.0000 0.0000

Null Hypothesis Summary: Normalized Restriction (= 0) C(4) C(6) Value 1.062843 0.350201 Std. Err. 0.053114 0.163619

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38