Global Derivative Debacles

The following sections are included:

• DEDICATION
• PREFACE
• ACKNOWLEDGEMENTS
• ABOUT THE AUTHOR
• CONTENTS
• LIST OF FIGURES
• LIST OF TABLES
• LIST OF BOXES

At a time when the world economy is engulfed into the mother of all financial crises, it is indeed tempting and opportune to find derivatives guilty as charged for creating financial chaos. This book is not an indictment of financial derivatives to be feared as “financial weapons of mass destruction” nor is it a call for multilateral disarmament or signing a nonproliferation treaty! Derivatives may be feared but they cannot be avoided nor ignored (abstinence is not an option) as they permeate many of the key goods and services which are at the core of modern life: for example, the price of energy is largely influenced by oil and natural gas derivatives and the cost of securitized consumer finance (variable rate home mortgages and automobile loans) embodies interest rate derivatives and credit default swaps…

Showa Shell Sekiyu K.K. is the 50%-owned Japanese subsidiary of the oil giant Royal Dutch Shell. In early 1993, it announced a staggering foreign exchange loss amounting to ¥125 billion or $1.07 billion (five times the company's pretax profit). In fact, when Showa Shell's President, Takashi Henmi, first informed the Anglo–Dutch parent's executives, they assumed that the decimal point was erroneously transmitted and they kept requesting a correction expecting losses in million rather than billion of dollars.

On June 19, 1965, in the heyday of the Bretton-Woods system of fixed exchange rates, the First National City Bank — the second largest American commercial bank with 177 offices in 58 countries—announced a loss of $8 million. The loss was attributed to unauthorized forward speculation on the pound sterling by a Belgian trader in the bank's Brussels branch. The amount of the underlying transactions was rumored to be close to $800 million. For First National City Bank — also known as Citibank — the year 1965 had commenced with a two-for-one stock split and ended with record operating profit of $94 million in spite of the one time loss of $8 million…

Bank Negara — Malaysia's central bank — reported on March 31, 1994 staggering foreign exchange losses of Malaysian Ringgit M$ 5.7 billion (equivalent to $2.1 billion), which followed an even larger loss of M$9 billion in 1992 ($3.3 billion). Jaffar bin Hussein—Bank Negara's long serving governor—was forced to resign on April 1, 1994 the day following the disclosure of the mammoth foreign exchange losses. Under normal central banking practices, such losses would have been the result of costly and legitimate but unsuccessful attempts by Bank Negara's at stemming the rise of its currency due to speculative capital inflows (see Box A). Indeed, in January 1994, The Economist reported that Bank Negara had declared war on “currency speculators,” who were buying Ringgits in anticipation of its appreciation. “But as the world's foreign exchange dealers well know, Bank Negara has long been a big punter in the currency market itself. In the last two years, its boldness has been matched only by its incompetence.” Indeed, as early as 1988, Jaffar had announced that to the traditional goals of providing safety and liquidity in managing its foreign exchange reserves, Bank Negara henceforth would add “profit optimization and market expertise,” which soon became a code word for currency speculation.

Hedge funds are often associated with Wall Street excesses and capitalistic greed. Indeed outsized compensations for hedge funds managers — in the billions rather than the millions as in the case of T. Boone Pickens take-home pay of $1.4 billion in 2005—routinely capture headlines in the financial press. When disaster strikes hedge funds, it is also of outsized magnitude as with the demise of Amaranth Advisors LLC, which announced on September 20, 2006 a loss in excess of $5 billion. Reportedly, the losses were due to massive bets placed on natural gas futures and they were incurred over a relatively short period of three weeks. When “margin calls” from the New York Mercantile Exchange (NYMEX) came knocking at Amaranth's door, only liquidation of the hedge fund $9 billion in assets could clear the slate. Unlike the much publicized debacle of Long-Term Capital Management (see Chapter 15), which reverberated throughout financial markets around the world, Amaranth's demise hardly caused any ripples and, in very short order, its losing portfolio was taken over by J.P. Morgan Chase and the Citadel Hedge Fund. It had set an all time record in the annals of global derivative debacles and yet the massive losses were absorbed painlessly by the global financial system. Was it the calculated yet daring risk-taking predicated on expert knowledge of the inner workings of the natural gas market which drove Amaranth to fail? Or was it foolhardy and reckless bets placed on the weather by ill-disciplined traders, who believed that they could repeatedly beat the market by taking mammoth futures positions in the natural gas market? From the perspective of the US consumer' best interests how could the NYMEX allow one player to dominate and therefore manipulate the market without enforcing position limits? More generally, should regulatory agencies control futures markets more tightly?

In the annals of financial debacles that rocked the 1990s, Metallgesellschaft (MG)'s loss of $1.3 billion was the first case of “derivatives malpractice” to bring a giant industrial firm to the brink of bankruptcy. In December 1993, Metallgesellschaft reported massive losses at its US oil subsidiary — Metallgesellschaft Refining and Marketing (MGRM)—which were traced to mammoth oil derivatives positions estimated at 85 days of Kuwait oil production (160 million barrels of oil). The oil derivatives positions were rumored to be the necessary hedging counterpart of an ambitious marketing program whereby MGRM had offered its US customers long term price guarantees on the delivery of petroleum products. Only a massive $1.9 billion rescue package mounted by as many as 150 German and international banks staved off bankruptcy for Metallgesellschaft, long known as a conservative blue-blood pillar of the German industrial establishment. Yet, it was not fraud as in the case of Barings SA, nor lax operating controls as in the case of Sumitomo, nor entrapment as in the case of Procter & Gamble. Rather it was a case of daring financial engineering based on somewhat tenuous assumptions about the inner working of oil markets that were ill-communicated and ultimately not shared between the audacious (possibly reckless) American “child” and its conservative German “parent.”

On June 13, 1996 Sumitomo reported a staggering loss of $2.6 billion due to copper trading activities on the London Metals Exchange. Sumitomo — one of the largest and oldest Japanese trading companies—laid the blame unambiguously on its former chief copper trader Hamanaka Yasuo: “These transactions were made solely by Yasuo Hamanaka himself. Hamanaka abused Sumitomo's name, and continued on with such unauthorized trading.” The losses had apparently accumulated over a period of several years and one wonders how the cash-flow trail of trading losses could go undetected for so long: was Hamanaka truly acting alone? Or was Sumitomo engaged in a grand scheme of copper price manipulations and using Hamanaka as a scapegoat when found out…

Allied-Lyons — better known for its teabags and its teacakes than for its forays into the currency market—announced on March 17, 1991 a stunning $269 million foreign exchange loss (approximately 20% of its projected profits for 1991). Facing a sluggish economy, its treasury department had developed a sophisticated scheme that gambled not so much on the absolute level of the dollar/sterling exchange rate as on its volatility. This gamble was achieved through a combination of currency options known as straddles and strangles that in this particular case would have produced profits had the exchange rate turned out to be less volatile than the option premium implied…

On February 6, 2002, Allied Irish Banks (AIB) disclosed that its US subsidiary Allfirst Financial Inc. had incurred a staggering loss of $691 million. The loss was traced to foreign exchange trading activities conducted by its currency trader John Rusnak. It was later revealed that the currency losses started as early 1997 and had been fraudulently concealed by the rogue trader from the senior management of the bank. The loss was significant enough to cut Allied Irish Banks' 2001 consolidated earnings by 60% and deplete the bank's capital by 10%…

On February 25, 1995, shocking news rocked the City of London. The venerable House of Baring was on the verge of collapse. The Sunday Times headlines bannered…

On January 24, 2008 at 8 am (Paris time) Société Générale (SoGen) announced in a terse press release that it had been the target of a fraud amounting to the modest amount of €4.9 billions ($7.2 billions). Ironically, the mother of all derivatives debacles had hit SoGen's equity trading desk—its inner sanctum for which the bank was most admired. Trading in SoGen's stock was suspended while the international financial community reeled in disbelief. A young trader Jerôme Kerviel was accused of building mammoth positions in stock index futures which he had hidden through fake offsetting trades. How could a junior trader fool the control systems of one of the most sophisticated bank? Why did he do it? Or was Kerviel made a convenient scapegoat for SoGen's acquiescence of one of its traders' reckless but highly profitable trades. The saga of wild speculation cloaked in deceit of what soon became “l'affaire Kerviel” is recounted next.

On April 13, 1994, Procter & Gamble announced a one-time pretax charge of $152 million against net income. The loss resulted from the early closing of two seemingly innocuous leveraged interest rate swaps, which Procter & Gamble had entered into with Bankers Trust as a way of reducing financing costs. For a company with over $30 billion in sales which reported net income of $2.2 billion in fiscal year 1994, this noncash charge was hardly life threatening. And yet the episode — by pitting in a landmark lawsuit a blue-chip American multinational corporation against one of the pillars of the financial establishment—redefined the relationship between Main Street industrial firms and their Wall Street investment bankers. Indeed Procter & Gamble alleged that it had been played, manipulated, and deceived by Bankers Trust and initiated a lawsuit against the latter. The landmark lawsuit was settled out of court and allowed Procter & Gamble to pay a much reduced amount of $35 million. Bankers Trust which was then proudly proclaiming in one of its advertisement “Risk wears many disguises. Helping you see beneath its surface is the strength of Bankers Trust” saw its wings clipped and came out of this imbroglio with its good name tarnished and the “Trust” under a cloud…

Gibson Greeting cards are more likely to conjure images of Santa Claus than being associated with Wall Street's daring and possibly unscrupulous financial engineers. The Cincinnati, Ohio-based manufacturer of consumer products specializing in greeting cards and wrapping paper had sales revenue reaching $547 million in 1993 with profits of $20 million that same year. Gibson's unlikely and traumatic foray in the world of arcane derivatives was motivated by the desire to reduce funding costs. In 1991, Gibson had raised $50 million in fixed rate debt: the coupon interest rate was set at 9.33% with repayment of principal staggered over the period 1995 to 2001. When interest rates started to decline, Gibson unfortunately found itself unable to prepay the bond issue because of a restrictive clause in its indenture…

Municipal finance conjures up images of cautious and conservative investment in safe low-yielding tax-free bonds. When Orange County declared bankruptcy in December 1994 after announcing a loss of $1.65 billion it sent shock waves through capital markets: the $1 trillion municipal bond market lost one percent of its value while other California municipal bonds (exclusive of Orange County) lost as much as 3–4% in value…

Long-Term Capital Management (LTCM) was a hedge fund like no other. Its relentless delivery of low volatility outsized returns for the first four years of its existence was unparalleled. Its demise and near-collapse in the fall of 1998 was as calamitous as its rise had been spectacular. Indeed the world economy had very narrowly escaped the abyss but regulators failed to draw any lessons which would have avoided the current crisis. At its apogee, in early 1998, with debt of $125 billion and off-balance sheet derivatives exposure in excess of $1 trillion piled up on a puny equity capital base of $4.7 billion Long-Term Capital Management had perfected financial leverage to a science. Unlike other derivatives debacles discussed in this book LTCM precipitous collapse stoked fear of systemic risk—that is of a domino effect engulfing the entire global financial system—so much so that the New York Federal Reserve Bank coerced fourteen major Wall Street firms — which were LTCM main creditors — to come to its rescue with a bail-out package of $3.6 billion. This chapter retraces the saga of the rise and fall of LTCM and exposes the alchemy of its phenomenal successes which also seeded its collapse.

In the mother of all derivative debacles which nearly brought down the insurance colossus AIG the villain is a relatively recent financial product known as the credit default swap (CDS). How could one of the premier global insurance company, consummate in the art of underwriting risk, lose its way in writing insurance against credit risk? How could a derivative akin to a form of insurance policy against bond default unleash the default AIG itself?. First we need to explain how CDS became a key linchpin of the securitization revolution to understand AIG's collapse.

On July 13, 2012 JP Morgan Chase & Co announced a stunning trading loss of $5.9 billion which wiped out more than $25 billion of the bank's market capitalization. The losses originated from the bank's Synthetic Credit Portfolio (SCP) which is itself part of the Chief Investment Office (CIO). This derivative debacle represented a significant misstep — if not an outright stumble — for JP Morgan Chase Chairman and CEO Jamie Dimon. Once vaunted for his risk management prowess in steering the bank deftly through the subprime crisis, Dimon was generally regarded as one of the most steadfast and savvy chieftains of the banking world. How did JP Morgan allow what began as a benign effort at hedging the bank portfolio to morph into a mammoth position in the credit market — which nicknamed it half-mockingly as the “London Whale”? Was it a deliberate attempt by the bank to bypass the Volcker rule in the new Dodd-Frank Act? How could JP Morgan Chase, which decades earlier had pioneered the new Value-a-Risk (V@R) metrics and was known for its expertise in risk management, seem so dysfunctional in taming its synthetic portfolio? How did a savvy giant banking institution allow the “London Whale” to be savagely harpooned by hedge funds?

The collective wisdom of the financial services industry should make the conclusions of this book redundant. The lessons of each derivative debacle were all self-evident and yet “Plus cela change plus c'est la même chose”: the name of the derivatives and techniques involved have changed and multiplied over the years while the debacles grew significantly larger but the same prudential principles which guide the wise management of financial activities in both financial and non-financial firms continue to be ignored or violated: from the rogue trader's $8 million loss at the Citibank's branch in Brussels in the mid-1960s to SoGen's $7.2 billion blowout and AIG's $150 billion bailout in 2008 it is déjà vu all over again …. This chapter consolidates the many lessons learned from the perspectives of non-financial firms, financial institutions, regulatory agencies and investors.

The following section is included:

• INDEX