ALM's Effect on the Financial Crisis

For those of you who haven't yet taken FIN 300 or above, this may be a little over your head, but duration is a critical financial concept and I'd encourage you to read this anyways. Briefly, duration is a measurement of how sensitive a cash flow (most typically a bond) is to interest rate fluctuations. The most common duration measurement is called modified duration, which provides a fairly reasonable estimate for price (the present value of cash flows) changes given a small change in the interest rate. For example, if a bond has a modified duration of 2.50, and the interest rate rose one percent, the price of the bond would drop 2.50% percent (remember, interest rate increases equals bonds price decreases). Understand that this is only an estimate, but it is what banks and insurance companies typically use and for fixed cash flows, it is fairly reliable.

Asset/Liability Matching (ALM) is a critical component of financial risk management that all financial institutions use to at least some extent. Basically, the idea is that the companies want the durations of their assets and liabilities to match. So, if you can set up your assets and liabilities in a manner that there durations are equivalent, any movement in interest rates will affect both the assets and liabilities roughly equivalently. Thus, your company won't experience significant write downs whenever interest rates move the "wrong" way.

So anyways, this defensive strategy has been reasonably effective in years past, because for the most part, the cash flows of assets and liabilities were more or less fixed. The problem today is that so many financial institutions are using various obscure derivatives that have cash flows that vary in both timing and amount. More critically, those changes in timing and amount are highly correlated with interest rates. For example, consider a collateralized mortgage agreement (CMO) which produces cash flows based on the mortgage payments of a whole pool of borrowers. If interest rates drop, suddenly not only are the cash flows discounted at a different rate, but people are going to pay off their mortgages much quicker (because they'll refinance their mortgages) and the timing of the cash flows is shifted forward - note that this is actually a bad thing because less interest is being paid. As you can probably imagine, duration quickly loses it's credibility in situations such as these. In fact, their are other measurements that more accurately measure interest rate sensitivity that indicate that duration's sensitivity estimates aren't even close to the actual sensitivity.

So from holding new more complicated derivatives such as CMOs, banks and insurance companies have been exposed to massive amount of risk that they completely overlooked. Suddenly their value assets and liabilities change in markedly different ways leading to potentially large losses in surplus (assets minus liabilities) if interest rates move the "wrong" way. Furthermore, with interest rates being so ridiculously volatile recently, these risks are becoming a greater concern.

Now understand, this is the more or less most basic overview of the situation possible, but hopefully it sheds a little light onto why we actually learn about issues such a duration. If you have any questions or concerns regarding any of this feel free to respond and I'll gladly do my best to clear them up. Also, it should be noted that all this information comes from lectures in my FIN 432 class. I asked the Professor (Steve D'Arcy) for some links regarding this matter, and he explained that this problem is largely overlooked and unreported; thus, there wasn't much pertaining to it that was accessible online.