Case Study: Collapse of Long-Term Capital

Management
Background of LTCM

This article explains the causes of collapse of a major speculative Hedge Fund (Long Term
Capital Management) way back in 1998. This fund was set-up by some very famous people,
namely, John Meriwether from Salomon Brothers, Myron Scholes and Robert C Merton among
other important names.

The fund was setup as a fixed-income arbitrage, statistical arbitrage and Pairs Trading fund
combined with some high leverage and because the master hedge fund Long Term Capital
Portfolio L.P. failed in the late 1990s. Salomon Brothers were already an expert in this area.

The company used complex mathematical models to take advantage of fixed income arbitrage
deals usually with US, Japanese and European government bonds. The capital base grew due
above average returns initially and the company decided to invest the capital and had run out of
good bond-arbitrage bets. These trading strategies were non-market directional and were not
convergence trades. By 1998 the firm had extremely large positions in merger arbitrage, S&P
500 volatility options and became a big supplier of S&P 500 Vega. Because these differences in
value were minute the firm decided to take highly leveraged positions to make a significant
profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over
$124.5 billion with assets of around $129 billion, for a debit to equity ratio of over 25 to 1.

Causes of Collapse

The causes of the LTCM collapse were is no way linked to the East-Asian financial crises of
1998.

There were some events in 1997 that led to this happening. On Monday, October 27, the DOW
dropped 554 points. This 7% market share loss was termed as black Monday and the New York
Stock Exchange shut down twice in an attempt to calm the market. Salomon Brothers’ exit from
the arbitrage business in July 1998 further aggravated the situation.

The Russian Financial Crisis of August and September 1998 which was caused due to the default
of the Russian Government bonds further contributed to these losses. This was called the
“Ruble” crisis and it resulted in the Russian Government devaluing the ruble and defaulting on
its debt. Declining productivity and an artificially high fixed exchange rate between the ruble and
foreign currencies to avoid public turmoil and a chronic fiscal-deficit were events that led to the
crisis. The economic cost of the war in Chechnya (estimated at $5.5 billion) also caused this. The
firm had investments in Japanese and European bonds and knowing that the Russian Crisis
would affect the value of these bonds, the panicked investors sold their holdings and purchased
US Government Bonds.
LTCM had to liquidate a number of positions at a highly unfavourable moment and suffer further
losses. The company which was proving almost 40 percent returns up to this point experienced a
flight to liquidity. The equity value of the firm tumbled from $2.3 billion at the start of the month
to just $400 million by September 25, 1998. With liabilities still over $100 billion this translated
to a leverage ratio of more than 250 to 1.

The total losses were found to be $4.6 billion. The losses in the major investment categories were
(ordered by magnitude):

 $1.6 billion in swaps

 $1.3 billion in equity volatility
 $430 million in Russia and other emerging markets
 $371 million in directional trades in developed countries
 $286 million in equity pairs (such as VW, Shell)
 $215 million in yield curve arbitrage
 $203 million in S&P 500 stocks
 $100 million in junk bond arbitrage
 no substantial losses in merger arbitrage

The Subsequent Bailout

Wall Street feared that the downfall of LTCM could have spiralling effects in the global financial
markets causing catastrophic losses throughout the financial system. Goldman Sachs, AIG and
Berkshire Hathaway on September 23, 1998 offered to buy out the funds partners for $250
million and decided to inject $3.75 billion and to operate LTCM within Goldman’s own trading
division. The final bailout was $3.65 billion.

LTCM continued normal operations after that

Risk Management Case Study: Sumitomo

Derivatives Losses
Background of the case

This article explains the causes of the losses and the impact on the financial world due to the
Sumitomo Copper Derivatives trades caused by excessive manipulation by one of its key and
trusted employees Yasuo Hamanaka. He was believed to be an expert in Risk Management. He
had a star trader status and was vested with executive decision-making powers by the firm.

Sumitomo owned large amounts of copper that was warehoused and stored in factories as well as
numerous futures contracts. Hamanaka controlled 5% of the worlds copper supply, which may
sound like a very small and insignificant amount, but given the fact that copper is illiquid
because it is physical in nature and the logistics of buying and selling it are not as simple as
financial commodities, a five percentage holding is quite significant.
Sumitomo also benefitted from the commissions on the other copper transactions that were
handled by the company. Commissions were handled by the percentage of the value of the
commodity being sold and delivered.

Causes of the Losses

There were some losses that Sumitomo had incurred just when Hamanaka had taken charge. He
tried to recover the losses by taking huge positions in copper commodity futures on the London
Metal Exchange. He tried to use the firm’s large cash reserves to both corner and squeeze the
market and kept the price artificially high for the entire decade leading up to 1995 and garnished
premium profits on the sale of Sumitomo’s physical assets.

This of course attracted the attention of the exchange and it gave a warning to Hamanaka who
then struck a deal via Merrill Lynch for USD 150 million, which enabled him to trade at LME.
He borrowed money from several banks without any authorization from his seniors. He used the
funds either to buy copper or pay for the collateral he was required to deposit at the LME to
cover loss making positions. By 1990 he was reporting huge trading profits to the top
management by showing invoices of the fictitious options trades which he had created through
some nexus with some brokers. Whenever anyone attempted to short the market he would pour
more cash into positions thereby sustaining the price and outlasting the shorts, simply because he
had more cash. The long cash positions forced anyone shorting copper to deliver the goods or
close out their position at a premium.

Unlike the US, the LME had no mandatory position reporting and no statistics showing open
interest. Basically traders knew the price was too high, but they did not have the exact figures of
how much Hamanaka controlled and how much money he had in reserve. In the end most cut
their losses and had Hamanaka have his way. Nearly a decade after this market manipulation
took place in 1995 due to the resurgence of the mining in China the price of copper started to
revive which further inflated the prices. Sumitomo was exposed to losses because the market was
headed for a big drop and shorting the positions then would result in an even bigger loss at a
faster rate.

Analysts felt that the debacle was a result of Sumitomo’s poor managerial, financial and
operational control systems, which enabled Hamanaka to carry out unauthorized trading
activities undetected by the top management. There was a lack of effective monitoring and
supervision of his trading activities.

The sorts of risks that cause this loss are market risk, operational risk – supervision and fraud –
market manipulation.

The Aftermath

Analysts were concerned about the Sumitomo losses as it came after two major corporate
disasters – Barings and Daiwa and felt that it would lead to a serious introspection among
various financial regulators and trading firms to improve existing regulation and trading
procedures.
Sumitomo was able to overcome the losses since it had a net worth of $6bn and another $8bn in
hidden reserves. The losses estimated to be $2.6bn amounted to only 10 per cent of Sumitomo’s
annual sales. Sumitomo was also able to prevent further escalation of losses by aggressive
liquidation of its uncovered position under its new president Miyahara. Hamanaka was of course
transferred out of his trading post.

Hamanaka was charged with forging one of his supervisor’s signatures on a form and convicted.
Sumitomo’s reputation was tarnished as many people believed that the company could not have
been ignorant of Hamanaka’s hold on the copper market, especially because it profited for
years from it.

Traders argued that Sumitomo must have known of Hamanaka’s wrongdoing because the
company threw more money at Hamanaka every time speculators tried to shake his price.
Sumitomo responded by implicating JPMorgan Chase and Merrill Lynch as funders of the
scheme, revealing that the banks had granted loans structured as future derivatives. Sumitomo,
JPMorgan Chase and Merrill Lynch all were found guilty to some extent. As a result, JPMorgan
Chase’s case on a similar charge, related to the Enron scandal and Mahonia Energy, was hurt.
Meanwhile, Hamanaka served his sentence without comment. Since the copper market
manipulation, new protocols have been added to the LME to make a repeat less likely.

Risk Management Case Study:

Metallgesellschaft AG (MGRM)
Background of the case

This German conglomerate is owned largely by some very big banks in Germany like Deutsche
Bank, Dresdner Bank to name a few as well as the Kuwait Investment Authority. The Energy
group subsidiary of this conglomerate (MG Refining and Marketing (MGRM – hereinafter
referred to as the firm) which deals with petroleum products reported a loss of round-about $1.5
billion in December 1993.

The Firm had exposure to short forward positions of certain amounts of petroleum every month
over 10 years. These positions were slated to make profits since the forward price was at a
premium over spot. These deals had an “option” clause involving the NYMEX futures contract
on oil. The Options clause entailed that if the front-month NYMEX futures price exceeded the
forward price the counterparties could terminate the contracts early. On exercise The Firm would
be required to pay in cash one-half of the difference between the futures price and the fixed price
times the total volume to be delivered of the contract. This would be attractive to the customer if
they were in financial distress and simply no longer in need for oil.

Given the fluctuations in the oil market prices, The Firm employed a “stack and roll” hedge
strategy using long NYMEX futures contracts. The delivery months used were short-dated along
the lines of the call options used. The Firm went long in futures and entered into OTC energy
swap agreement to receive floating and pay fixed. The futures positions accounted for 55 million
barrels and the swap positions accounted for 110 million barrels and these positions introduced
credit risk for The Firm.

Causes of the losses

The hedge was created with a view that the market would be in backwardation (where spot prices
are higher that futures prices) which is normally the case. However, the market shifted to
contango (where futures prices are higher than the spot prices) greatly increasing the cost of the
hedge. The gain due to the short positions was more than offset by a loss due to the futures
positions.

This caused the following problems:

1. The contribution due to the size of the The Firm’s total open interest was a considerably
larger percentage of the total and liquidating these positions would be very difficult.
There was also a danger of not having adequate funding in case of immediate margin
calls.
2. Over the life of the hedge the cash flows would have matched out. But the firm
encountered problems in finding necessary funds to maintain the position.
3. A hedge is supposed to transfer away the market risk entirely. But the firm was accused
of speculation instead of hedging due to the funding issues caused by the contango effect.
Official records state that they were exposed to a position 85 days worth of the entire
output of Kuwait.
4. If oil prices were to drop, MGRM would lose money on their hedge positions and would
receive margin calls on their futures positions. Although gains in the forward contract
positions would offset the hedge losses, a negative cash flow would occur in the short run
because no cash would be received for the gain in the value of the forward contracts until
the oil was sold. Although no economic loss would occur because of their hedge strategy,
the size of their position created a funding risk
5. The stack and roll strategy future aggravated the losses because in a contagno market the
spot decreased more than the futures prices. US versus German accounting
methodologies – German accounting standards also compounded MG’s problems. Lower
of Cost or Market (LCM) accounting is required in Germany. In the U. S., MGRM met
the requirements of a hedge and received hedge accounting. Therefore, in the U.S.,
MGRM actually showed a profit. Their hedge losses were deferred because they offset
the gains of their forward fixed rate positions. Using LCM, however, MG was required to
book their current losses without recognizing the gains on their fixed-rate forward
positions until they were realized. Since German accounting standards did not allow for
the netting of positions, MG’s income statement was a disaster. As such, their credit
rating came under scrutiny and the financial community speculated on the demise of MG.
This drastically changed the market arena for MGRM. Their swap counterparties required
additional capital to maintain their swap positions and the NYMEX imposed supermargin
requirements on MGRM more than doubling their performance bond requirement. If
hedge accounting had been acceptable in Germany, MGRM’s positions may not have
alarmed the marketplace and they might have been able to reduce their positions in the
OTC market without getting their eyeballs pulled out.
The major cause of the losses was actually the size of the position which created a funding risk

Orange County Case

The importance of a good risk management team that oversees investments is critical in an
institution. This is especially more so for a County. The Orange County ran into very troubled
investment waters in 1994. Litigation and a buoyant economy helped right many of the wrongs.
It was a very expensive way, of about $1.6 billion from a wrong way bet on interest rates in an
investment pool that caused Orange County to take a hard look at its system of checks and
balances as far as their investments were concerned.

Robert Citron the principal player in the Orange County debacle took money raised by public
departments for public works, placing yields over safety of the resources. He invested this money
in leveraged portfolios.  These portfolios were linked to interest rate securities. The pool he used
for these leveraged investments had the county and 241 associated entities.

Robert Citron had an enviable track record of managing the investment pool that had become
about $7.5 billion by the 90’s. The various participants in the pool hoped to get better returns for
their currently idle cash which they could deploy later for public works. Citron who had been
managing the funds since the 70’s had created reserves worth several millions of dollars leading
up to the debacle in 1994. Citron had a fairly free hand in investment decisions with low priority
on reporting. The public agencies too had pressure on them not to raise taxes, but to deliver on
development. This meant most of these agencies were looking for higher returns on their funds.

Citron’s strategy was dependent on the presumption that the interest rates for the short term
would be fairly low compared to medium term investments. Citron managed to get the best
returns by taking on more risk. He used highly leveraged portfolios to invest his money to raise
the value of his $7.5 billion pool to $20 billion. He achieved this by investing in reverse
repurchase agreements, which permitted him to use securities bought by the pool as collateral for
further investments. Naturally this left the door open on the possibility that the value of his
original collateral fell, and he would be required to provide more collateral in the event of a loss.

There was an oversight committee comprised of the board of supervisors, who unfortunately
despite having to supervise Citron, lacked the financial sophistication to do so. So Citron
continued, undisturbed. His principal advisors for the kind of instruments he could invest in were
Merrill Lynch. Citron invested in a variety of Government paper. He also invested in derivatives,
$2.8 billion of it, in order to increase his bet on the yield curve structure. Inverse floaters, index
amortizing notes and collateralized mortgage obligations-Citron’s pool had a finger in every pie.

These instruments’ complexity and Citron’s lack of reporting made the returns that were better
than most other counties all a bit of magic that could not be understood and most certainly not
predicted. The portfolio under Citron’s guidance was having a golden run, and nobody was
complaining.
That run became a walk and very soon a descent into investment hell, when the Federal Reserve
started raising interest rates. This meant the calls for more collateral increased from his
counterparties. The notional losses increased and members of the pool started requesting their
shares back. This resulted in the form of a liquidity trap.

The counterparties started liquidating billions of dollars of the pool collateral. Government
agencies invested in the pool were looking at ways to exit. The Orange County board of
supervisors then declared bankruptcy to prevent investors from further removing their funds. A
public auction of the investments in the pool was conducted and the proceeds parked in safer,
liquid short-term government stocks. Post this restructuring, losses still stood at $1.69 billion.

Orange County took recovery bonds as debt. The county had to cut severely on its spending and
social services provisions. The local economy was doing very well and in a matter of 18 months
was able to haul itself out of bankruptcy.

Orange County was able to turn itself around from a position of temporary weakness by
instituting stronger governance reforms.

An oversight committee, an internal auditor who reported to the Board of supervisors, written
policies on investment and a definite plan and orientation for long term financial planning were
some of the changes Orange County made. The policy gave top priority to liquidity and safety of
principal, with yield having secondary priority. The needs of the county by ploughing their funds
for investment were certainly not for higher yields at the cost of incurring losses, due to market
risk in the case of Orange County. To this end the County’s investment policy disallows
investment in reverse repos, structured notes and options. It requires that timely reports be
presented to the board. It clearly says that any decision making member cannot accept gifts in
kind or cash.

The Orange County also reached a settlement with Merrill Lynch through litigation. As part of
the settlement Merrill Lynch had to pay the county $400 million for improper advice towards
risky instruments that were clearly at odds with the funding needs of the pool. Thirty other firms
that included accountancy firms, law firms also reached settlements with the County. This
money was then used by about 200 municipal agencies. These settlements made by officers of
the court reached $864 million.

What then are the lessons that we need to take away from the Orange County Crisis?

1. A good track record and a star performer are great during a good run. It is important to be
aware that where there are higher returns there is higher risk as well, which will up its
ante sooner or later.
2. It is important, and critical for a good framework in place that understands the
organisations investment objectives. Planning for these investment objectives needs to be
a decision members of the pool make. The investment decisions should not be centered
on one or two individuals. If not this can lead to poor oversight and eventually very
costly mistakes.
 3. Organisations that invest long by borrowing short will definitely have to face liquidity
risk.
4. A framework of investment policies, guidelines, and risk reporting and independent and
expert oversight can help make a happy marriage of risk-averse investors with investment
objectives to investment actions.
5. Clear and easy risk reports that are comprehensible by all parties is fundamental to good
investment. This way all parties concerned will be on the same page with regards to what
is happening to the investments. Complicated instruments or strategies that cannot be
explained to third parties must be eschewed, particularly by the risk averse.

WorldCom Accounting Scandal: The Wrong

Call (Part 1)
From its beginnings as a long distance call player to handler of Internet data traffic, WorldCom
was a spectacular firework in the sky before it crashed out as one of the biggest bankruptcies
America has witnessed in its corporate history.

WorldCom carried more international voice traffic than any other company. It carried a large
amount of the world’s Internet traffic. WorldCom owned and operated a global IP (Internet
Protocol) backbone that provided connectivity in more than 2,600 cities and in more than 100
countries. It also operated 75 data centres on five continents.

WorldCom reached the spot of the largest long distance provider and Internet data traffic player
largely through acquisitions – 65 of them. The company spent $60 billion in acquisitions and had
$41 billion in debt between 1991 and 1997. Starting from pennies a share the company steadily
climbed to selling at $60 a share in 1990.

Of its many acquisitions two were of particular importance.

 The MFS Communications acquisition which helped WorldCom to obtain UUNet, a

major supplier of Internet services to business.
 The acquisition of MCI communications that made WorldCom one of the largest
providers of business and consumer telephone service.

Soon WorldCom became the darling of Wall Street, with several recommendations from analysts
to buy. This helped WorldCom in the way that they could make more acquisitions, by using
stock. By acquiring MFS Communications WorldCom was adding data services and local
services in their basket of long distance services. MCI a strong player in the long distance
communications arena, helped consolidate WorldCom’s position in the market. WorldCom had
acquired MCI after a competitive bid by British Telecom for $18 billion. WorldCom offered $30
billion in its stock and took $5 billion of MCI’s debt.

WorldCom had made its large 65 acquisitions in the span of just 6 years. Mergers and
acquisitions are tricky business. The integration with the acquiring company has to be done at
several levels, with the staff and the numbers at both the firms being in sync over time.
Managements have to do this exercise tactfully and persistently to achieve one whole. At the end
of it the acquisitions must add to shareholder value. Typically, financial integration must take
place using GAAP or general accounting practices so that the financial practices, methods of
viewing profit, debt across the acquired companies are seen through the same lens.

WorldCom unfortunately did not take the task of integration with the same alacrity and
enthusiasm as acquiring them. WorldCom’s CEO Ebbers while making the right broad strokes
with his brush, did not take the time to etch out and work out the finer details of operations. The
acquired entities continued to behave separate of WorldCom. The supposed benefit of merging
was lost with the first line of employees critical to projecting a whole entity, customer service
botching it up badly. The different teams of customer service continued to be rewarded for
aggressive sales at the cost of each other.

WorldCom closed three important MCI technical service centers that contributed to network
maintenance only to open twelve different centers that were duplicate and inefficient. 
WorldCom purchased a large number of local exchange carriers or clercs to provide local
service. All the capacity was expensive and severely underutilized, introducing a high degree of
redundancy into the system.

The financial reporting was creative at its best. WorldCom would write down in one quarter
millions of dollars in assets it acquired while, at the same time, it included in this, charge against
earnings the cost of company expenses expected in the future to give an impression that profits
were rising. This gave the impression that while losses were high in the current quarter the losses
appeared to reduce in the forthcoming quarters.

In the case of MCI, WorldCom reduced the book value of some MCI assets by several billion
dollars thereby increasing the value of “good will,” that is, intangible assets brand name by the
same amount. This enabled WorldCom each year to charge a smaller amount against earnings by
spreading these large expenses over decades rather than years. The net result was WorldCom’s
ability to cut annual expenses, acknowledge all MCI revenue and boost profits from the
acquisition.

With regards to accounts receivables WorldCom put up many of MCI’s receivables for sale. This
resulted in creating a smaller reserve for bad debts and therefore higher earnings.

Then WorldCom attempted to acquire Sprint, another major player in the long distance call
market. This deal was not allowed on the basis that it would create a monopoly, wherein the play
of market and competitive forces would not be allowed to function

WorldCom Accounting Scandal: The Wrong

Call (Part 2)
The year 2000 was a major year for WorldCom There had been a slowdown in the long distance
market for some time, it reached its lowest in 2000. Long distance players like WorldCom and
Sprint were looking at new avenues of profit like broadband and were moving away from long
distance. The market was way too overcrowded with players big and small eating into each
other’s margins. Wall Street and other Venture Capitalists put the stopper on new funds worried
over the overheating in stocks. This meant not only was there no new funds; there was also a
slowing of revenues generated that would have helped sustain their businesses. The low margins
and low demand added to the telecom sectors predicament.

2002 saw WorldCom declaring bankruptcy. It also came to light that there were several
accounting violations. WorldCom admitted to a $9 billion adjustment from 1999 through 2002.
There was admission of improper accounting where operating expenses were accounted for as
capital expenses, making earnings look larger.

This two way reduction of new funds and revenues meant Bernie Ebbers faced margin calls, i.e
put up more collateral for outstanding loans. He decided to sell his common share but was
prevented by the board saying it would lead to a drop in share prices and reduce investor
confidence. He relented to the Board’s decision as he felt the fortunes of WorldCom would
improve and the house put in order. Ebbers had borrowed against his shares. The Board had
sanctioned loans to Mr. Ebbers against these loans. This is generally considered a poor return on
company assets, and in the case of Mr. Ebbers the loans advanced attracted interest rates of just
2%, which were way below the average interest rates.

Arthur Anderson who was supposed to oversee WorldCom’s accounts is said to have a blind eye
over several discrepancies. Citigroup provided cheap funding to Ebbers in return for the role of
lead underwriter for its $5 billion bond issue through Solomon Smith and Barney, its investment
arm, which it owned. Salomon Smith Barney’s telecommunication analyst Jack Grubman who
was supposed to provide an independent opinion based on fundamentals, hyped the WorldCom
stock with ‘buy’ recommendations. Ebbers and Grubman were known to be extremely close with
favors extended for good recommendations. Grubmans insider view was seen by many as a
conflict of interest. Mr.Grubman continued to give high ratings to WorldCom right until 2002
when he finally deemed it necessary to tag it risky. For his role in recommending a high rating
for WorldCom stocks nad misleading investors and conflict of interest. Mr.Grubman was fined
$15 million and banned for life from securities transactions. These corporate buddy relationships,
with low regard for professional integrity cost investors several million dollars and eroded share
value.

This brings us to the question, who uncovered what happened at WorldCom. This was the doing
of Cynthia Cooper, internal auditor at WorldCom. As a result of her teams investigations they
discovered that WorldCom had manipulated accounts and had been trying to hide almost $4
billion in misallocated expenses and phony accounting entries. She brought to the notice of
Arthur Andersons some of the gaps in WorldCom’s accounting but was paid no heed. This only
strengthened her concerns and she investigated further. Her report stated that $2 billion
accounting entry for capital expenditures that had never been authorized and that it had reported
operational expenses as capital expenditure to reflect higher earnings. She was asked by
WorldCom CFO Scott Sullivan to delay her report. Cynthia Cooper went ahead and reported her
findings to the boards’s audit committee.

In her interview with TIME she had this to say about the fall of WorldCom: “A lot of people
think that the fraud caused the downfall of WorldCom. In my view, neither the fraud nor the
discovery of the fraud caused the downfall. The company’s stock had fallen from a high of $64 in
June of 1999 to 83 cents at the time the company announced the [earnings] restatement. So I
think you have to understand the role of certain corporate decisions — loading the company
with debt, poor acquisition decisions, also the Internet mania that swept the country and the
telecomm implosion in general.”

WorldCom could have saved itself from Operational risk with better corporate governance,
strategies for quick and effective methods to help the acquired companies align with the acquirer
strategy, employ ethical and fair methods and report financial accurate details of the company’s
accounts.

Investors understand industries and companies face ups and downs, only if WorldCom had
understood this and been transparent with its investors, it would have taken a happier trajectory

China Aviation Oil – Derivative Losses

China Aviation Oil (Singapore) Corporation Ltd (“CAO”) is the largest physical jet fuel trader in
the Asia Pacific region and the key supplier of imported jet fuel to the PRC civil aviation
industry. CAO’s key businesses include jet fuel supply and trading, trading of other oil products
and investments in oil-related assets. Incorporated in Singapore on 26 May 1993, CAO was
listed on the mainboard of the Singapore Exchange Securities Trading Limited since 6 December
2001. Their parent company, China National Aviation Fuel Group Corporation (CNAF) is a
large State-owned enterprise in the PRC. It is the largest aviation transportation logistics service
provider in the PRC, with a diverse portfolio of businesses, comprising aviation fuel distribution,
storage and refuelling services at more than 160 PRC airports. CNAF holds about 51% of the
total issued shares of CAO. BP Investments Asia Limited, a subsidiary of oil major, BP, is a
strategic investor of CAO, holding 20% of the total issued shares of CAO.

In 2005, CAO had losses of USD 550 million. This lead to it collapsing, until it was revived by
CNA. How could CAO with monopoly in its area of business get into this position? It did this by
speculation in fuel options. What started out by trading in derivatives to control volatility moved
onto speculative trading in fuel options for profit, which eventually went very bad.

In the beginning CAO traded in over-the-counter (OTC) swaps and exchange-traded futures as
hedging instruments to manage the risk in its business of procuring oil. The company traded in
relatively riskless back-to-back option positions on behalf of client airline companies. This
earned fee income for CAO from the bid/ask spread on these trades without exposing it to any
volatility in oil markets.
At the end of the third quarter in 2003, CAO started conducting speculative option trades to
profit from favourable market movements in oil-related commodities. It traded them on the basis
that oil prices would move upwards. The trading strategy involved simultaneous purchase of call
options and sale of put options. This effectively created a synthetic long position in oil without
the need to purchase the commodity outright. As oil prices increased, the calls that were
purchased were exercised at a profit. The puts that were sold were not exercised and CAO
profited from the premiums that had been collected when these options were sold. These trading
strategies had however not been reviewed/approved by the Board of Directors before trading
began, and there was no risk committee in place to review these transactions on an ongoing
basis.

This strategy worked well for CAO till the fourth quarter, when they estimated prices would go
southward. Its CEO Chen Jiulin, began initiating trades with numerous counterparties that
created a short position which would profit if oil prices  moved below USD 38.00/bbl.  This was
accomplished by selling calls and buying puts with the result that CAO was in a short position at
the end of 2003. In 2004 the prices exceeded USD38.00, resulting in CAO having to fund margin
calls on its open short positions. The accumulated losses from these closed positions amounted to
approximately USD 390 million. In addition, the company had unrealized losses of about USD
160 million, bringing the total derivative losses to USD 550 million. CAO concealed these
losses. The international standard for accounting for derivatives IAS 39 required that these
transactions be market to market with gains and losses reflected in current earnings.  As in most
of the world, Singapore companies were required to adopt FRS 39 (the IAS 39 equivalent) as of
1 January 2005.

A review was then conducted by Price Water House Coopers. They opined that since specific
methods to value derivatives trading were not present in FRS 39, CAO should have adopted the
Industry standards, rather than saying that there were no clear norms. The key problem PwC
noted was that the valuation of the derivatives was wrong in that it treated the intrinsic value as
the fair value of its options. It should have instead taken into account the intrinsic value and the
time value. This would mean that the length of the time to maturity of the option, the volatility in
the spot price of the underlying commodity, interest rates and other factors would have been
taken into account.

PwC represented CAO’s valuation against its own to show the variation:

Q1 Q2 Q3 First 9
months
CAO EBT 19.0  19.3 11.3 49.6
PwC -6.4 -58.0 -314.6 -379.0
adjusted
EBT

The oil prices had been steadily rising in 2004. If CAO had used its intrinsic approach, it still
would have shown losses. To cover its losses the company adopted a risky strategy to sell long-
term options to generate premiums that would cover the cost of closing out the loss-making
option contracts. CAO was trying to compensate for their existing losses by collecting premiums
on options that had the potential to generate further losses in the future.

Case Study: Taisei Marine and Fire

Insurance
The Taisei Marine and Fire Insurance (TMFI)company along with Nissan Fire & Marine and
Chiyoda Fire & Marine Insurance was part of the Fortress Re pool. Fortress Re was responsible
for inward reinsurance business. TMFI  had large property and casualty business in Japan.

TMFI was Japan’s 15th in the list of top non-life insurers. TMFI’s solvency margin (assets over
liabilities) was 815%. The norm set by Japanese authorities being 200%. This margin was
calculated to assess financial strength. TMFI had large volumes of domestic Japanese property
and casualty business. It also had a large volume of inward reinsurance (reinsurance business
accepted by the insurer or reinsurer, but not given up to another insurer) through its US
reinsurance pool managed by Fortress Re, a North Carolina based reinsurance managing agency.

Fortress Re used traditional methods and products to offset risk. Later on though, it started
implementing finite insurance, and by 2000 was using only this method to offset its risk.
Typically insurers set aside a percentage of the payouts in the event the cause of insurance
occurs. If the amount does not cover the insurer will pay for the rest. This means lower costs and
it also lowers the level of potential risk an insurer can face. Fotress served as the pool’s
reinsurance manager. The Fortress Re pool included aviation, marine and many other reinsurance
products with aviation comprising 70% of the portfolio. Fortress ceded 25% of its business to
Carolina Re, a Bermuda-based reinsurer, which was owned by the principals and close family of
Fortress executives.

The pool made large profits. Then there were a number of aviation related accidents which
triggered claims. These included TWA off Long Island, New York (1996), Swissair off the coast
of Nova Scotia (1998), EgyptAir of the East Coast of the US (1999), Alaska Airlines off the
West Coast of the US (2000) and Concorde in Paris (2000).

Then 9/11 happened and the strain of all the previous claims meant TMFI went bankrupt as it
could not provide sufficient reinsurance protection against this major event. The players other
than Fotress Re in the pool were not fully cognizant of the risks inherent in the portfolio. Fotress
Re was granted liberty by other members of the pool to conduct business on their behalf and to
arrange reinsurance protection. A trust that was misguided and ultimately fatal.

The finite reinsurance model allowed Fortress Re to claim reinsurance claims payments from the
finite reinsurers and it paid premiums to cover these deals over a 5-year period. As the risks were
spread over time, the future premiums were not accounted for as current liabilities on the books
of the pool members, giving a false impression of profitability.
The aviation insurance regulators state that airline companies must buy insurance from local
insurers (fronting insurance companies). Then, these local insurance companies are allowed to
transfer all risks to in this case the Fortress Re pool which in turn reinsured but with a limit on
coverage (finite reinsurance).

Through its reinsurance pool, Fortress Re assumed inward insurance from other fronting
insurance companies. Then other companies such as Taisei would participate in the pool and
assume risk. For further cover, a finite risk program was implemented to spread the risk over a
long time period.

The actual risks were masked by accounting risk transfer procedures. If TMFI had strictly
adhered to accounting risk transfer procedures, it would have treated the premiums as deposits,
since it was a financial agreement not a risk transference. In this event the company should have
to make an adjustment to take all the losses into the income statement and consider the effect on
its solvency margin.  This procedure might have made it difficult for TFMI to determine if the
risk had actually been transferred and if there was sufficient catastrophe cover. So despite having
a 850% solvency margin, TMFI could not cover the claims, as their risk assessment was
inadequate. Finite insurance while lowering cost in the books did not provide for real cover when
the impossible happened.

TMFI went bankrupt thanks to not being aware what it had signed up for and how badly their
liabilities might be in the event of a worst case scenario. Nissan and Chiyoda the other members
of the pool managed to miss bankruptcy thanks mostly due to their size.

TMFI is a case wherein there was Insurance Risk. Their uninsured exposure being a part of the
Fortress Re pool was low even for low-frequency high-impact events. The low chance of an
event like 9/11 needs to be factored, managed, and potentially hedged.

TMFI as a member of the pool should have clearly understood terms of its contracts, the
liabilities thereof and therefore had in place risk mitigating strategies. It should have along with
other members calibrated risk as close as possible and undertaken measures to limit it.

Northern Rock: A Case in Low Frequency

High Impact Event
In 2007 Northern Rock experienced a bank run, the first since 1886 by its depositors. The bank
saw a withdrawal of 3 billion pounds which constituted about 11% of Northern Rock’s retail
assets. It had to ask the Bank of England to intervene to save it. It eventually was taken over by
Bank of England and later Virgin money.

Northern Rock was originally a mutual building society. It became a bank in 1997. Northern
Rock could therefore move into all areas of banking. It chose to however focus on the residential
mortgage business. Its strategy revolved around securitization and funding, and it used mortgage
backed securities, extensively.
Problems in the MBS market in the US, resulted in a loss of faith by depositors. Despite
assurances from The Bank of England, the UK’s Financial Services Authority (FSA) and
Treasury (the UK government’s finance office) that Northern Rock was indeed solvent, the run
could not be contained.

It may be considered irrational that depositors decided to do this, but global developments in this
market make it less so.

Northern Rock used securitization quite extensively. This involved the bank collating its loans
such as mortgages into one package. This portfolio was then sold to the capital market. The
mortgage portfolio is usually bought by other financial institutions or Special Purpose Vehicles,
Structured Investment Vehicles (SIVs), or Conduits of Northern rock. The buyers then sold them
as securities, rated according to the mortgage underlying them. In this way Northern Rock passed
on the loan to other agencies through SPVs extending them a line of credit in the event that they
fell short of money to renew the securities.

The subprime market in the US was growing rapidly, with mortgage loans being combined with
Collateralized Debt obligations (CDOs). The rating agencies usually gave CDOs high rating on
account of the low number of low risk loans within it. Buyers of MBS and CDO’s included
hedge funds, banks the world over or conduits established by banks or special purpose vehicles
(SPV).

When housing prices started to crash, these buyers were affected. These banks, including
Northern Rock started facing liquidity constraints. Further, a rise in the cost of funding meant it
became increasingly difficult to roll-over short-term debt issues. Liquidity in the inter-bank
market became worse resulting in a tier based interest rate system.

Banks with exposures to the MBS market started to feel the pinch. Most of their capital was tied
up with mortgage assets and it looked unlikely that they could offload it to the MBS market. The
liquidity crunch also meant that they could not continue to give credit to their SPVs. The market
uncertainity resulted in some of the following issues:

 a sharp fall in asset classes

 uncertainty as to the risk exposure of banks
 drying up of the  credit markets, particularly MBS securities
 Poor to nil liquidity in MBSs and CDOs markets

Concerns about the real value of these instruments started setting in and investors were looking
away from them. This was true globally. This resulted in conduits facing a serious liquidity
crisis. These conduits were funding long-term mortgages (and other loans) by issuing short-term
debt instruments. The lack of liquidity meant banks could not finance off-balance-sheet vehicles
and had to take assets back on to the balance sheet or hold on to assets they were planning to
securitize. This process was known as re-intermediation. Northern Rock went through this
process.
Northern Rock with its central strategy of securitization relied heavily on short term money
market funding. It had to keep several of its mortgage assets on the balance sheet. The interest
rates or cost of money increased sharply to a point that the yields on its mortgage assets were
lower than the borrowing cost. The final nail on the coffin was the bank run, with depositors
clamoring for their money.

At this juncture the bank had to turn to the Bank of England (BoE) for assistance. BoE was the
lender of last resort (LLR). Assistance was given in return for high quality assets and a penalty
rate of interest. The timeline of this assistance looked like this:

 September 14th 2007: The BOE’s role of LLR was activated on 2007 at a penalty interest
rate of 1.5 pp above Bank Rate
 The government further offers to guarantee all existing NR deposits.
 NR was given an additional unlimited facility at the BOE secured on the collateral of all
NR assets.
 October 9th 2007: the government applies the guarantee not only to existing deposits but
to all new retail deposits
 Guarantee applies to not only retail deposits but to most other creditors

The bank run stopped only when BoE provided guarantee to all deposits.

What happened with Northern Rock was an instance of low probability but high impact or LPHI.
If a bank is in this situation it is also the toughest to get out of as Northern Rock learned. If this
instance were to happen it would mean the sale of the bank, and to maintain reserves for such an
event may not be realistic. Therefore risk analysts within the bank and supervisors tend to gloss
over these instances. Mitigation of such an instance though can be factored into its risk strategy.

Northern Rock’s heavy dependency on securitization and short-term wholesale market funding
meant such an event was in the offing. The bank had not anticipated a bank run in addition to a
drying up of liquidity whereby not only would it not be in a position to fulfill its obligation, but
lead to the collapse of the bank itself. Northern Rock had not taken the precaution of taking lines
of credit from other banks should such a LPHI event occur. The bank and supervisors ignored
liquidity warnings a phenomenon that is referred to as disaster myopia. At the time of its bank
run Northern Rock had 62% of wholesale funding as against the average of other UK banks of
45%.

The government’s role in this is worth scrutiny. The government stepped in and provided a full
guarantee on depositor’s money. This was applicable for new customers and their depositors as
well albeit with an interest penalty. This meant the tax payer was paying for this guarantee. Any
fall in prices of housing meant in case the bank went insolvent they would find the price of the
mortgaged houses would be cheaper than the value of the defaulted mortgage. This difference
would be borne by the tax payer. By guaranteeing depositors money and protecting Northern
Rock during the bank run, the importance of the Debt Protection Scheme (DPS) was brought into
question. It was intended to protect financial stability rather than individual users. This gave the
impression that the government would step in and protect consumer rights, superseding the
conditions laid by DPS.
In the end Northern Rock teaches us the importance of not having a portfolio of assets leaning
heavily into a market. A diversified portfolio is far better. Secondly, no scenario is impossible. It
may be impractical to maintain reserves for such a scenario, but solutions must be discussed. The
impact of financial scenarios is no longer local but glocal, Northern Rock experiencing the
impact of the sub-prime mortgage crisis in the US, despite having no investments there. Its
strategy of being largely in the securitization and MBS market raised fears in its depositors’
minds though. The importance of greater transparency in instruments and risk procedures as well
as their subsidiaries can be seen in the Northern Rock example.

Bankers Trust Case Study

P&G like several other profitable companies was looking at ways to hedge itself from risk. They
were also looking at methods at making small gains, where possible. In case the gains turned to
be losses, since they were offset by the small gains. They did this by using plain swaps of fixed
for floating rate debt or vice versa. They also used futures, options and currency trades to hedge.

P&G decided to go into high risk complex derivatives through Bankers Trust which was known
to be a top player in risk management. P&G had discussed hedging by Bankers Trust using
vanilla swaps. It entered into two such contracts. These contracts were floating rate notes in
Deutsche marks and dollars. The bets were made on the assumption that the interest rates would
fall. P&G further upped the stakes by betting twenty to one in favor of an interest rate fall.

There was the buzz that rates would indeed increase at some point and therefore positions must
be cleared before it did happen. In 1994, Greenspan went ahead and did what the market was
predicting. He raised rates. P&G lost heavily. Its Chief Financial Officer claimed that they had
no knowledge of the intricacies of the contract and were thus unaware of the losses that could be
made. Bankers Trust on its part had not clearly detailed the underlying risk inherent in their
contracts.

P&G sued BT for $195million. BT claimed that P&G had in place its own panel of experts to do
interest rates forecasts and that they had not complained when they made handsome gains.
Eventually both the parties settled out of court for a net of $78 million. Bankers Trust also settled
with Federal Paper Board Company, Gibson Greetings, Air Products and Chemical, and Procter
& Gamble for $93 million.
Bankers Trust contended that P&G could have learnt more about the complex derivatives it was
channeling funds into. P&G countered by saying BT should have made them fully cognizant of
the risks that were involved in these instruments, since P&G had given their funds in good faith.
Since the returns were good P&G had no real reason to go into the details of the contract.

A series of recordings among employees at BT were heard out, in which employees discussed
how the contracts that P&G had got into were not unlike a keg of gunpowder waiting to explode.

One of the oft quoted excerpts from those recordings (6500 of them) from Newsweeks archives
reads as follows:

“It’s Nov. 2, 1993, and two employees of Bankers Trust Co. are discussing a leveraged
derivative deal the bank had recently sold to Procter & Gamble Co. “They would never know.
They would never be able to know how much money was taken out of that,” says one employee,
referring to the huge profits the bank stood to make on the transaction. “Never, no way, no
way,” replies her colleague. “That’s the beauty of Bankers Trust.””

P&G claimed that by the time it was fully in the know about how the derivative worked they
were asked to fork out $40 million as extra financing costs. They then learnt that BT was using a
proprietary model to calculate these costs. Just as the costs the payouts were not fully clear
either.

Lessons Learnt

BT suffered from serious reputational risk, lost the trust of its valued clients and laid bare the
process lacunas in its system.

BT was dealing with complex derivatives and getting into them with clients who trusted them
and considered them to be the best. Instead what transpired was that BT misused this trust by not
being transparent in their dealings. If they had clearly explained to their clients all the risks and
costs that may need to be borne in the event the hedge went against them, clients would have
further investigated them.

BT got over confident and seemed to have bred a culture of deceit and profits at any cost. It also
seems to have not placed adequate emphasis on communication between employees regarding
client matters. The attitude of it’s alright to scam the client by not keeping them fully informed
seemed to be rampant within the organization. Perhaps it was more a case of employees having
to reach targets at any cost. Unfortunately that pressure translated into the most undesirable form
with BT employees not putting their clients on top.

In the case of clients like P&G who while being financially savvy may not have been fully aware
of how the more complex derivatives worked, BT could have spent time earlier on making them
aware of the risks. P&G went after BT with a vengeance and made several incriminating
allegations against them, warning off other valuable customers who might have done business
with BT.

If BT employees and management had been more discreet in their internal communication and
far more transparent in their conversation with clients it would have done their business and
reputation a world of good.

Case Study: Equity Derivative Losses at UBS

In 1997, United Bank of Switzerland lost heavily in the equity derivatives market, with estimated
losses  pegged between $400 and $700 million. It is said to have lost $700 million in long
positions in LTCM (Long Term Capital Management). The UBS case speaks strongly for strong
internal risk control measures and adherence to the same.

UBS even at that time was extremely tight lipped about what really happened. It transpires that
UBS equity derivatives department was an entity in its own right. An independent department
that did not fall under the purview of the rules and regulations that one expects to be followed in
a large bank like UBS. The positions of senior risk management and quantitative analytics was
headed by the same individual. This meant that  he was reviewing business decisions that he had
generated. His bonuses and incentives were tied to his trades.This meant the scope for
independent review was very slim.

The losses have been also attributed to a poorly developed  financial model  as compared to its
competitors leading them to over-value and take long positions on many derivative positions.
Sources within UBS at that time said that the bank had started implementing a Value at Risk
system. Unfortunately the derivatives desk came last in the implementation, with one of the
reasons being the team not providing adequate co-operation.

UBS had a portfolio choc-a-bloc with long dated options. British tax laws when they were
changed hit all banks but particularly UBS on account of the size of its portfolio. The same was
true in the case of Japanese warrants of which UBS held a much bigger portfolio than most other
banks. But what UBS or anyone else could not anticipate was the fall of the Japanese economy
which was considered one of the strongest. With the break of the Japanese warrants the losses
mounted for UBS.

UBS had considerable positions in LTCM. 60% of the UBS investment was in the form of
options and 40% as direct investment. Naturally in hindsight it is easy to say this was a bad
decision. LTCM had the crème de la crème of the derivatives world (John Meriwether from
Salomon Brothers, Myron Scholes and Robert C Merton of the Black Scholes and Merton model
and Nobel prize winners). They had positions in the European, American and Japenese markets.
Everyone wanted a piece of the LTCM pie. The fall of Russian bonds, Japanese bonds and the
clampdown on LTCM when things went horribly wrong meant UBS was digging deeper into
losses. The positions with LTCM were  approved by Mathis Cabiallavetta the CEO of UBS. If
this investment in this bundled format went through stress tests or other forms of risk assessment
is not fully known.

In the end  UBS had to be merged with the smaller Swiss Bank Corporation on their terms in
1997 with the LTCM debacle unfolding in 1998. The CEO came under much flak for selling
rather than handling the crisis. The importance of assessing risk valuation models and controls
through a risk department as well as external agencies are not for textbooks in finance alone but
to be implemented and listened to with caution. Theoretically UBS did the best it could, but
keeping their ear to the ground and not putting all their eggs in one basket was a lesson they
learnt a little too late.