Lessons from Financial

Disasters
26-year-olds with computers are creating
financial hydrogen bombs
Lessons From Recent Losses
Losses publicly attributed to derivatives amounted to
over $30 billion during 1990s
Only 0.03% of total notional amount of over $100 trillion
in 1999
Some managers, directors, and trustees have taken the
extreme step of eliminating all derivatives from their
portfolios increased portfolio risk
Derivatives may be used to hedge risks

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Losses Attributed to
Derivatives
Derivatives can lead to large losses if used
inappropriately (Table 2-1)
Just focusing on these losses may be misleading:
Some derivatives were used as a hedge to offset other
business risks losses may be offset by operating profits
Losses due to hedging program
Losses due to outright speculation
Size of losses is directly related to recent large movements
in financial markets
1994: holders of U.S. Treasury bonds lost $230 billion
Derivative contracts are zero-sum games
Loss to one party is a gain to the other

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4
Perspective on Financial
Losses
Other notable financial catastrophes not related to
derivatives
Bank Negara, Malaysias central bank, lost more than $3
billion in 1992 & $2 billion in 1993 after bad bets on
exchange rates
Bet on British Pound to stay in European Monetary System
(EMS)
Sep 1992: Bank of England, under heavy attack by
speculators, let sterling drop out of EMS
George Soros made profits of $2 billion

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Perspective on Financial
Losses (contd)
French government poured more than $15 billion into
Credit Lyonnais, which suffered huge losses during
1992-93 recession
Early 1980s: the U.S. savings and loans industry lost
$150 billion as short-term interest rates zoomed up
1990s: Japan financial institutions were sitting on a total
of perhaps $960 billion in non-performing loans
Dec 2001: Enron went bankrupt, followed by WorldCom
7 months later, which wiped out equity once valued at
$80 billion for Enron and $115 billion for WorldCom.

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Perspective on Financial
Losses (contd)
Table 2-2: total costs of banking disasters
Derivatives losses appear to be minor incidents

Banking system as a systematic source of trouble, nearly

always due to bad loans (credit risk)

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Perspective on Financial
Losses (contd)
Fundamental misallocation of capital, due to:
Banks themselves
Insufficient lending standards
Poor risk management
Governments
Poor bank supervision
Ill-advised government intervention
Unsustainable economic policies
Banks do not generally diversify their credit risk across
countries or industries and are also highly leveraged

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Baringss Fall: A Lesson in Risk
Feb 1995: Barings PLC, a venerable 233-year-old bank, had gone
bankrupt
One single trader, 28-year-old Nicholas Leeson, lost $1.3 billion from
derivatives trading wiping out the firms entire equity capital
The chief trader for Barings Futures in Singapore
Supposed to do only arbitrage trades
But accumulating positions in Nikkei 225 Index Futures betting market
going up
Notional positions on Singapore and Osaka exchanges added up to $7
billion
Market fell more than 15% in Jan/Feb 1995
Also sold options on Nikkei 225 Index Futures betting on a stable market
Unable to make cash payments required by exchanges

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Baringss Fall: A Lesson in Risk
(contd)
Amazing lack of controls at Barings
Leeson had control over both the trading desk and the back
office conflicts of interest
Back office is to confirm trades and check that all trading
activity is within guidelines
Traders should have a limited amount of capital they can
deal with and be subject to closely supervised position
limits
Most banks have a separate risk management unit that
provides another check on traders

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Baringss Fall: A Lesson in Risk
(contd)
Singapore and Osaka exchanges failed to notice the size
of positions
Osaka: Barings accumulated 20,000 contracts each worth
$200,000 8 times the next largest position
Leeson was unsupervised due to his great track record
1994: made $20 million 1/5 of the total firms profits
Also due to the matrix structure reporting along both
geographic and functional lines decentralization

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Baringss Fall: A Lesson in Risk
(contd)
Senior bank executives were aware of the risks involved
Approved cash transfers of $1 billion to make margin calls
Ignored internal audit warning excessive concentration of
power in Leesons hands
Shareholders bore the full cost of the losses
Share price went to zero
Bondholders: 5% recovery rate
ING acquired Barings at 1
Victim of operational and market risk

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Metallgesellschaft
A hedge that went bad to the tune of $1.3 billion
Losses incurred by its American subsidiary, MG Refining
& Marketing (MGRM) in the oil futures market
Germanys fourteenth largest industrial group with
58,000 employees
Offered long-term contracts for oil products so that
customers could lock in fixed prices over long periods
By 1993: entered into contracts to supply 180 million
barrels of oil products over a period of 10 years
The commitments exceeded many times MGRMs refining
capacity
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Metallgesellschaft (contd)
Rolling Hedge
The long-term exposure was hedged through a series of
short-term (about 3 months) futures contracts, that were
rolled over into the next contract as they expired.
1993: Oil cash prices fell from $20 to $15 a billion
dollars of margin calls that had to be met in cash
German parent did not expect to have to put up such
large amounts of cash
Senior executives at the U.S. subsidiary were pushed out,
and a new management team was flown in from Europe

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Metallgesellschaft (contd)
The new team immediately proceeded to liquidate the
remaining contracts, which led to a reported loss of $1.3
billion
To liquidate or not to liquidate?
Creditors, led by Deutsche bank, stepped in with a $2.4
billion rescue package
Share price of MG: 64 24 marks (wiping out half of the
market capitalization)
Victim of market and liquidity risk

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Orange County
A case of uncontrolled risk taking
$7.5 billion belonging to county schools, cities, special
trusts, and the county itself
Bob Citron used reverse repurchase agreement to
borrow $12.5 billion and invested in agency notes with
an average maturity of 4 years
1994: interest rate hikes caused paper losses on the
fund that led to margin calls from brokers

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Orange County (contd)
Bob claimed no risk in the portfolio because he was
holding to maturity and did not report the market value of
the portfolio

Losses were allowed to grow to $1.8 billion

Victim of market and liquidity risk

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Daiwa
1995: Daiwa Bank announced that a 44-year-old trader
in New York, Toshihide Igushi, allegedly had
accumulated losses estimated at $1.1 billion
Daiwa was the twelfth largest bank in Japan and the loss
only absorbed one-seventh of the firms capital
Igushi had concealed more than 30,000 trades over 11
years, starting in 1984, in U.S. Treasury bonds
As the losses grew, Igushi exceeded his position limits to
make up for the losses. He started selling, in the name of
Daiwa, securities deposited by clients at the New York
branch
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Daiwa (contd)
The problem arose at some point Igushi had control of
both the front and back offices
Unlike other Japanese workers who were rotated
regularly, he had been hired locally
Daiwa failed to implement major changes and even
deliberately hid records and temporarily removed bond
traders in order to pass inspection by U.S. regulators
Daiwa relegated Igushi to a back office function. Even
so, he continued to transact, hiding behind other traders

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Daiwa (contd)
Result
U.S. regulators ordered the bank to close down its U.S.
operations
Regulators accused Daiwa of a pattern of unsafe and
unsound banking practices and violations of the law
Top management stepped down

Victim of operational and market risk

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Allied Irish Bank
Feb 2002: a 37-year-old rogue trader, John Rusnak, in
the US subsidiary Allfirst Financial had cost AIB $691
million in a currency losses, wiping out 60% of the banks
earnings.
Rusnak claimed that he consistently could make money
by running a large options book hedged in the cash
markets.
In fact, many of his positions were one-way bets that the
yen would appreciate, using forward contracts.
In 1997, he started to lose money and created bogus
options to hide his losses.

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Allied Irish Bank (contd)
Weak risk management system
Rusnak could enter false positions
He manipulated the prices used to value the positions

Victim of operational and market risk

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Risk Factors in Losses
Market Operational Funding Lack of
Controls
Barings Yes, Yes, rogue Yes
Japanese trader
Stocks
MGRM Yes, oil Yes Yes

Orange Yes, interest Yes Yes

County rates
Daiwa Yes, interest Yes, rogue Yes
rates trader
AIB Yes, foreign Yes, rogue Yes
exchange trader
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Lessons from Financial
Disasters
Private-Sector Responses
G-30 Report (1993)

The View of Regulators

Financial Accounting Standards Board (FASB)
Securities and Exchange Commission (SEC)

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G-30 Report
1993: Group of Thirty (G-30) issued a landmark report
on derivatives, Derivatives: Practice and Principles,
concluding that derivatives activity makes a contribution
to the overall economy that may be difficult to quantify
but is nevertheless both favorable and substantial.

The general view of G-30 is that derivatives do not

introduce risks of a greater scale than those already
present in financial markets.

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G-30 Report (contd)
In particular, the G-30 advises to value positions using
market prices and to assess financial risks with VAR.

These sound practice principles, however, are equally

valid for any portfolio, with or without derivatives.

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The View of Regulators
The explosive growth of the derivatives markets and
well-publicized losses have created much concern for
legislators and regulators, especially over the
unregulated OTC swap markets.
The trend is toward more transparent reporting of
financial risk, by using VAR measures.

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Financial Accounting Standards
Board (FASB)
Derivatives have been considered as off-balance-sheet
items, that is, did not generally appear in balance sheets
or earnings.
This practice was highly inadequate, since derivatives
are, in effect, assets or liabilities, like other balance sheet
items.

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Financial Accounting Standards Board
(FASB) (contd)
Jun 1998: FASB passed a new set of standards, No.
133, Accounting for Derivative Instruments and Hedging
Activities that unifies derivatives accounting, hedge
accounting, and disclosure in a single statement.
Effective Jun 15, 2000, FAS 133 requires derivatives to
be recorded on the balance sheet at fair value (quoted
market prices).

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Financial Accounting Standards Board
(FASB) (contd)
Changes in the market value of derivatives must be
reported in earnings.
For derivatives used as a hedge, the rules allow the gain
or loss to be recognized in earnings at the same time as
the hedge item.
Dec 1998: International Accounting Standards
Committee (IASC) issued IAS 39, moving toward
marking-to-market for all financial assets and liabilities,
not only derivatives.
By requiring marking-to-market, these new standards
confirm the trend toward more transparent reporting.
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Securities and Exchange
Commission (SEC)
Jan 1997: the SEC issued a ruling that requires
companies to disclose quantitative information about the
risk of derivatives and other financial instruments in
financial reports filed with SEC.
For the first time, companies have to disclose forward-
looking measures of risk.
SEC reviewed qualitative disclosure statements by U.S.
public corporations and found that the management
discussion was typically uniformative.

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Securities and Exchange Commission
(SEC) (contd)
To make information reporting more transparent, SEC
requires registrants to disclose quantitative information
of market risks using one the three possible alternatives:
A tabular presentation of expected cash flows and contract
terms summarized by risk category
A sensitivity analysis expressing possible losses for
hypothetical changes in market prices.
Value-at-risk measures for the current reporting period,
which are to be compared to actual changes in market
values.

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Conclusions
Derivatives disasters of the early 1990s served as
powerful object lessons in the need to manage financial
risks better.
The unifying theme behind these reports and regulations
is an increasing emphasis on risk management.
Better control of market risk through VAR systems is a
direct outgrowth of the derivatives markets.
By providing tools to control market risk, derivatives will
have fulfilled an important social function.

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