frm foundations allen, chapter 4: financial … foundations allen, chapter 4: financial disasters...

FRM FoundationsAllen, Chapter 4: Financial Disasters

• Hosted by David Harper CFA, FRM, CIPM

• Published Mar 10, 2012

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This tutorial is for paid members only. You know who you are. Anybody else is using an illegal copy and also violates GARP’s ethical standards.

Allen, Chapter 4: Financial Disasters

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Describe the key factors that led to and the lessons learned from the following risk management case studies:

• Chase Manhattan & Drysdale Securities

• Kidder Peabody

• Barings

• Allied Irish Bank

• Long Term Capital Management (LTCM)

• Metallgesellschaft

• Banker’s Trust

2012 FRM Foundations 1.c Allen, Financial Risk Management: Chapter 4

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Financial Disasters (Case Studies)


Misleading Reporting

• Chase/Drysdale

• Kidder Peabody

• Barings

• Allied Irish Bank

Unexpected market moves

• LTCM

• Metallgesellschaft

Conduct of Customer Business

• Banker’s Trust

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Chase Manhattan& Drysdale Securities

• In 1976, Drysdale obtained $300 million in unsecured borrowing

– But only had $20 million in capital

• Lost money on positions.

– Could not repay loans. Drysdale went bankrupt.

• Reputational damage to Chase (and stock price impact)


Chase/Drysdale

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Chase Manhattan &Drysdale Securities

Key FactorsKey Factors

• Chase failed to detect the unauthorized positions: Chase did not believe the firm’s capital was a risk.

• Inexperienced managers

• Did not correctly interpret borrowing agreements that made Chase responsible for payments due.

Lessons LearnedLessons Learned

• More precise methods required to compute collateral value

• Need process control: new products should receive prior approval “risk function”


Chase/Drysdale

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Kidder Peabody

• Between 1992 and 1994, Joseph Jett exploited an accounting-type glitch in order to book about $350 million in false profits (government bonds)


Kidder Peabody

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Kidder Peabody


• System did not present value (PV) forward transactions: allowed booking of artificial profits

• Management did not react to visible suspicions


• Investigate a stream of large unexpected profits

• Periodically review models and systems: do assumptions need to be updated?


Kidder Peabody

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Barings

• During 1993 to 1995, a junior trader (Leeson) took large speculative positions (Japanese stocks, interest rate futures, options) from the Singapore office

– Disguised as safe transactions on behalf of fake customers!

• Losses of ~ 1.25 billion forced Barings into bankruptcy


Barings

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Barings

• Market risk

– Leeson was short straddles on Nikkei 225. Hoped index would trade in narrow range; planned to pocket premiums. However, after Kobe earthquake (1/1995):

1. Sent index into a tailspin.

2. Earthquake increased volatility (adds value to both calls and puts) which “exploded” the short put options

• Credit risk

– Management of counterparty risk & reporting of specific instrument exposures to counterparties would have been an additional signal


Barings

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Barings


• Leeson was allowed to settle his own trades

• Management incompetence & poor supervision

• Poor reporting


• Absolute necessity of an independent trading back office

• Separation of trading and settlement functions

• Need to make thorough inquiries about unexpected sources of profits and/or cash movements


Barings

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Allied Irish Bank

• John Rusnak, a currency option trader, entered into massive unauthorized trades from 1997 to 2002, producing losses of $691 million.

– Was supposed to run small arbitrage

– But was disguising large naked positions


Allied Irish

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Allied Irish Bank


• Similar to Leeson (internal deception)

• Achieved by inventing imaginary trades


• Proprietary trading is a high-risk activity

• Risk management architecture is crucial

• Relationship between parent and overseas units needs to be clarified

• Strong and enforceable back-office controls are essential


Allied Irish

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Long Term Capital Management (LTCM)

• From 1994 to 1998, renowned quants produced spectacular returns with relative value (“arbitrage”-type) trades

• In Summer 1998, series of unexpected and extreme events (e.g., Russian rouble devaluation led to flight to quality)

– New York Fed coordinated a private bailout ($3.65 billion equity investment)


LTCM

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Long Term Capital Management (LTCM)


• Failure to supplement VaR with a full set of stress test scenarios

• Failure to account for illiquidity of positions during stress

• (Leverage too high?)

• (Too much faith in models?)


• Stress scenarios including extreme stresses and interaction between market & credit risk

• Incorporate liquidity

• Initial margin needed if counterparty is trader

• Greater counterparty disclosures


LTCM

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LTCM: Key factors (con’t)

Model risk #1: Models assumed normal distribution

Model risk #2: Extrapolation of historical returns. Did not anticipate once-in-a-lifetime event

Diversification: Risk models did not handle correlations that spiked during a crisis event

Funding liquidity risk: When firm lost ~ half its value in sudden plunge, lack of equity capital created a cash flow crisis

Market risk: Extreme leverage combined with concentrated market risk—LTCM had a balance sheet leverage of 28-to-1


LTCMLTCM

LTCM

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LTCM: Key factors (con’t)


Transparency and disclosure

Marking to market. “Conflict between hedging strategies and cash requirements”

Transaction types: pairs trading, risk arbitrage, and bets on overall market volatility

Liquidity squeeze: Asian crisis → Brazil devalued its currency → Flight to quality → Spreads increase → Value of LTCM collateral drops → LTCM liquidates to meet margin calls

Insufficient risk management: “underestimated the likelihood that liquidity, credit and volatility spreads would move in a similar fashion simultaneously across markets”

LTCMLTCM

LTCM

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Metallgesellschaft

• MGRM wrote (sold) long-term forward contracts to sell gas/oil

– Hedged with long positions in short-term futures (stack-and-roll hedge)

• As spot oil prices dropped, oil futures curve shifted to contango

– In 1993, creditors rescued with a $1.9 billion package


MG

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Metallgesellschaft


MetallgesellschaftMetallgesellschaft

Basis riskBasis risk

Liquidity riskLiquidity risk

Operational riskOperational risk

Shift!

MG

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Metallgesellschaft


• Stack-and-roll hedge exposes to basis risk

• Shift to contango created losses on roll return

• Accounting standards required recognition of futures losses but not forward gains!


• Short-term hedge against long-term contracts requires liquidity

• Uncertainty of roll returns

• Liquidity consideration may favor other than minimum variance hedge


MG

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Metallgesellschaft: Key Factors (con’t)

1. First factor was that the market shifted to contango (i.e., the futures price is greater than the spot price).

– Greatly increased the cost of the stack-and-roll hedge.

– Led to cash flow (liquidity) problems

2. Second factor was German accounting methods required Metallgesellschaft to show futures losses (i.e., from hedge) but could not recognize unrealized gains from the forward.

– These reported losses triggered margin calls and a panic, which led to credit rating downgrades.


MetallgesellschaftMetallgesellschaft

MG

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Banker’s Trust (BT)

• To reducing their funding expenses, Proctor & Gamble (P&G) and Gibson Greetings bought complex derivative products offered by BT

• Due to losses (e.g., P&G lost >$100 million in 1994), customers sued BT

– Claimed they were exploited because they were not sophisticated enough to understand their risks


BT

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Banker’s Trust


• Complex derivatives

• Evidence of some intent to deceive (Discovery evidence)


• Better controls for matching complexity of trade with client sophistication

• Need to provision price quotes independent of the front office

• Implications of internal communications that can later be made public


BT

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