# **III. Financial Crisis Failures**

## **_Inadequate Market Signals_**

As has been pointed out by various critics, market prices and credit ratings did not provide adequate or timely signals to banks (or their supervisors) on the buildup of risks during the ‘good times’. By contrast, once the crisis hit, and particularly after the U.S. authorities allowed the failure of Lehman Brothers in September 2008 allegedly in an attempt to restore MD, market participants punished the prices of bank securities harshly.

In order to validate this criticism, information was collected on the evolution since 2006 in the prices of different types of instruments – equity, debt and 5-year credit default swaps (CDS) – for a small set of U.S. banks (Citigroup, Bear Stearns, Lehman Brothers). Those banks were selected because they took, at least with hindsight, excessive risks and the financial crisis caused them to fail (Lehman Brothers, September 2008) or to be rescued via arranged takeovers (Bear Stearns, March 2008 – sold to J.P. Morgan) and _ad hoc_ government support packages (Citigroup, November 2008 and February 2009). As can be seen in Table 1, the securities used in the analysis (whenever available) span the capital structure of a typical large U.S. bank, and their different risk characteristics allow a comparison of their price sensitivity.

**Table 1: Typical Capital Structure of a U.S. Bank**

|**Type of Bank Security**|**Position in the Capital Structure**|**Main Risk of Loss**|
|---|---|---|
|Senior Debt|Outside regulatory capital|Regulatory intervention or bank default|
|Subordinated Debt<br>**_rption_**<br>**_ty_**|Tier II capital (if remaining<br>maturity is longer than 5 years)|Some interest deferral (without necessarily<br>triggering bank default) or debt‐equity exchange|
|Trust Preferred Shares (TruPS) and<br>**_so_**<br>**_aci_**|Generally Tier I capital|Interest deferral (without necessarily triggering bank|
|Enhanced Trust Preferred Shares (E‐TruPS)<br>**_Ab_**<br>**_Cap_**|(innovative hybrid securities)|default) or debt‐equity exchange|
|Preferred shares<br>**_Loss_**<br>|Tier I capital (particularly if<br>noncumulative and perpetual)|Dividend suspension (without necessarily triggering<br>bank default) or conversion to common stock|
|Common shares|Tier I capital|Bank losses|

_Source: CreditSights (29 March 2009)._ The movement of prices prior to and during the crisis, both across different instruments of the same bank and for each of the selected bank instruments vis-à-vis a suitable market benchmark, was analyzed. Market benchmarks were created by forming a composite (simple average) of similar instruments by appropriate peers for each of the selected banks. In the case of Citigroup, the peers were two other large U.S. diversified banks (JP Morgan and Bank of America), while in the case of Bear Stearns and Lehman Brothers the peers were the three other major stand-alone U.S. investment banks (Goldman Sachs, Morgan Stanley, Merrill Lynch). The purpose was twofold: (1) to identify the most risk sensitive instruments that provided the earliest warning signals; (2) to ascertain whether those price signals captured the bank’s idiosyncratic behavior as opposed to broader market-wide price movements. The objective of this exercise was to establish whether (and when) MD began to function for these banks in the crisis.

Appendix I contains graphs depicting the evolution in the price of different instruments for the three banks and their respective market benchmarks since early 2006. Appendix II describes 8