FRM Exam Part I · Learning From Financial Disasters

Funding Liquidity Risk: Metallgesellschaft, LTCM and Lehman

Updated 11 October 2026 · Fact-checked

Funding liquidity risk is the risk that a firm cannot meet cash or collateral calls when they fall due. Metallgesellschaft, LTCM and Lehman each failed because short-term funding or margin demands outran their ability to pay, even where positions looked sound. Match each case to its cause: rolled hedges, leverage, or repo dependence.

Understand Funding Liquidity Risk: Metallgesellschaft, LTCM, Lehman

Funding liquidity risk is the risk that a firm cannot meet its payment obligations, margin calls or collateral demands on time without large losses. Market liquidity risk is different. It is the risk that you cannot sell an asset quickly at a fair price because the market is thin. The two feed each other: falling asset prices trigger margin calls, forced sales push prices down further, and that triggers more calls.

The three cases show this in different forms. Metallgesellschaft (MG, 1993): its US unit sold long-dated fixed-price oil product contracts to customers and hedged with short-dated energy futures, rolled forward each month (a stack and roll hedge). When oil prices fell, the futures lost money and required cash variation margin immediately, while the gains on the customer contracts were not received until later. The hedge was not a bad economic idea in every view, but the cash timing mismatch created a funding crisis. Rolling a long futures hedge earns a positive roll yield when the market is in backwardation and incurs a cost when the market is in contango. The market was in backwardation for much of the period, which favoured rolling, but it shifted into contango in late 1993, so rolling became a rollover cost that added to MG's cash drain. The parent's new management then closed the US unit's positions, crystallizing losses. A key debate is whether the one-to-one stack hedge was over-hedged relative to the minimum-variance hedge ratio.

Long-Term Capital Management (LTCM, 1998) ran relative-value convergence trades with very high leverage, often cited as more than 25 to 1 on balance sheet, and large off-balance-sheet derivative positions. After Russia's default in August 1998, spreads widened instead of converging, and correlations across supposedly unrelated trades rose. LTCM had large positions that could not be sold without moving prices, so market liquidity and funding liquidity risk combined. Its VaR models relied on a short history and underestimated tail events. The Federal Reserve Bank of New York organised a private-sector rescue, not a taxpayer bailout.

Bear Stearns and Lehman (2008) relied on short-term wholesale funding, mainly overnight and short-term repo, to finance long-term, illiquid assets such as mortgage securities. When lenders lost confidence, they refused to roll repos or demanded higher haircuts, and the firms could not fund themselves. This is a run on a shadow-banking-style funding model. Lehman also used Repo 105 transactions, which were accounted for as sales to lower reported leverage at quarter-end, which raised transparency and governance concerns. Lessons: match the term of funding to the term of assets, hold liquidity buffers, stress test for margin and haircut increases, and disclose leverage honestly.

Key formulas to remember

Leverage ratio: Leverage = Total assets ÷ Equity; A 25-to-1 leverage means a fall of about 4% in asset value wipes out equity (1 ÷ 25 = 4%).
Equity loss from asset fall: Equity loss % = Leverage × Asset fall %; Valid when liabilities are fixed in value and the fall applies to all assets, with leverage defined as assets ÷ equity.
Repo haircut: Cash borrowed = Collateral value × (1 − haircut); A higher haircut means less cash for the same collateral, so more funding is needed from other sources.
Variation margin on a futures hedge: Cash call = Number of contracts × contract size × adverse price move; An adverse move is a price fall for a long futures position and a price rise for a short position. MG was long futures, so falling prices triggered cash calls, while a short position would gain on a fall.

How to solve Funding Liquidity Risk: Metallgesellschaft, LTCM, Lehman questions

Use this method for any question on these cases or on funding liquidity.

1Identify the firm and the event: MG (hedging with stack and roll), LTCM (leverage and convergence trades), or Lehman/Bear Stearns (repo funding).
2Name the core failure: cash flow mismatch, excessive leverage, or short-term funding of long-term assets.
3Decide whether the risk is funding liquidity (cannot pay) or market liquidity (cannot sell at fair price), or both.
4If numbers are given, compute leverage, equity loss or margin call with the formulas above.
5Check the trigger: falling prices, widening spreads, higher haircuts or lost confidence.
6Pick the lesson that matches: liquidity buffers, term matching, stress tests, lower leverage or better disclosure.
7Eliminate options that blame only market risk models or only fraud when the case turned on funding.

Quickest way: Case-to-cause matching

When to use it: Use it for conceptual multiple-choice questions where you must link a firm to its failure.

MG: think hedge, futures, rolling, margin calls, cash timing.
LTCM: think leverage, convergence trades, Russia 1998, correlations rising, Fed-organised rescue.
Bear Stearns and Lehman: think repo, haircuts, run, Repo 105.
Funding liquidity means cash and collateral; market liquidity means price impact of selling.
Reject any option that says the firm had no economic rationale; the exam stresses liquidity, not just bad trades.

Common mistakes in Funding Liquidity Risk: Metallgesellschaft, LTCM, Lehman

Treating funding liquidity and market liquidity as the same thing.
Both appear in the same crises and both involve cash.
Fix: Ask whether the problem is paying obligations (funding) or selling assets at a fair price (market).
Saying MG failed because its hedge was unhedged speculation.
Students remember large losses and assume speculation.
Fix: MG's hedge was intended to offset customer contracts. The problem was the cash flow mismatch and the rolling of short-dated futures against long-dated commitments.
Saying LTCM was bailed out by the government.
Later crises involved public support.
Fix: The New York Fed convened the rescue, but the capital came from private banks.
Describing Repo 105 as simple fraud in the sense of fake assets.
It is often summarised as hiding debt.
Fix: State it as repo transactions treated as sales to reduce reported leverage temporarily at quarter-end, which was misleading about leverage.
Computing equity loss by dividing instead of multiplying by leverage.
Mixing up leverage and the wipe-out threshold.
Fix: Equity loss % = leverage × asset fall %. The wipe-out fall is 1 ÷ leverage.

Worked examples

Example 1

A fund has assets of $500 million financed with $20 million of equity. Assets fall by 3%. What is the leverage and the percentage loss of equity?

Show the solution

Leverage = 500 ÷ 20 = 25.
Asset loss = 3% × 500 = $15 million.
Equity loss % = 15 ÷ 20 = 75%. Check: 25 × 3% = 75%.

Answer: Leverage is 25 and equity falls by 75%.

Example 2

Which statement best explains why Lehman Brothers failed in 2008? (A) It could not sell assets because the market for them was closed in a single day. (B) It relied on short-term repo funding for long-term illiquid assets, and lenders stopped rolling it. (C) It hedged with futures that required variation margin. (D) It used 25-to-1 leverage on convergence trades after Russia defaulted.

Show the solution

Lehman is linked to repo funding and a run, so look for short-term funding of illiquid assets.
Option C describes MG and option D describes LTCM.
Option A is vague and does not identify the funding mechanism.

Answer: (B) Lehman funded long-term illiquid assets with short-term repo, and the funding was withdrawn.

Exam tips

Link each firm to one headline cause and expect distractors that swap firms.
Know the difference between funding and market liquidity; many questions test it.
For MG, remember the rollover and the timing mismatch of margin cash versus contract gains.
For leverage questions, use loss % = leverage × asset fall %.
For Lehman, mention repo haircuts, run risk and Repo 105 accounting.

Practice questions from Learning From Financial Disasters

Funding Liquidity Risk: Metallgesellschaft, LTCM, Lehman: frequently asked questions

What is the difference between funding liquidity risk and market liquidity risk?

Funding liquidity risk is the inability to meet cash or collateral obligations when due. Market liquidity risk is the inability to trade an asset quickly without moving its price. They often reinforce each other in a crisis.

Why did the Metallgesellschaft hedge fail?

MG hedged long-dated fixed-price commitments with short-dated futures that were rolled. When prices fell, futures losses needed immediate cash margin while the offsetting gains came later. The cash mismatch caused a funding crisis and the positions were closed.

What lessons does LTCM teach for FRM Part I?

High leverage, crowded convergence trades and reliance on short-history models can fail together. Correlations rise in stress and positions cannot be unwound without price impact. Stress testing and liquidity planning are needed.

What was Repo 105?

It was a Lehman practice of treating certain repo transactions as sales so assets left the balance sheet temporarily at quarter-end. This made reported leverage look lower than it was, raising disclosure and governance concerns.