The largest trading loss in Canadian Bank History:

Bank of Montreal’s Natural Gas Derivatives Blow-Up

Carlos Blanco, Ph.D. Managing Director, Black Swan Risk Advisors,

Robert Mark, Ph.D., CEO, Black Diamond Risk Enterprises

The Bank of Montreal (BMO) has suffered from the largest trading loss in Canadian bank
history. After announcing losses in the C$350-450 million range on April 27th, in a move that
angered analyst and investors1, the bank revalued its commodities trading portfolio as at
April 30, 2007, resulting in trading losses of C$680 million.

The bank explained that these losses were bigger than it originally forecast after it adopted a
different pricing model to better assess the value of its natural gas OTC options contracts. A
few weeks before the announcement, the bank ordered an independent assessment of its
natural gas commodities trading policies and practices, including valuation methodologies.

These painful losses followed positive trading results in the prior fiscal year ending October
31st 2006, where the bank’s trading revenue (driven in part by gains in energy trading) more
than doubled to C$564 million.

BMO announced that its first-quarter earnings will have to be reinstated due to potential
trading "irregularities". BMO pointed out that C$509 million of the C$680 million trading
loss is part of the restated fiscal first-quarter results, and C$171 million is part of its fiscal
second quarter results , which ended April 30th. The after-tax losses, which include
adjustments in compensation, were C$327 million over the two quarters. In the context of
overall earnings for the bank, the trading loss represents about half of BMO’s quarterly
earnings. The bank’s bets began to sour last year at a moment when the OTC natural gas
options market became increasingly illiquid. The bank’s portfolio was adversely impacted by
a gradual drop in implied volatilities over the months preceding the announcement.

The revision also reflected concerns about the reliability of quotes from its main broker;
Optionable. BMO increased its dealings with Optionable, a brokerage firm speicalizing in
OTC derivatives for long maturities, as it expanded trading in natural gas options after prices
rose following Hurricane Katrina in 2005.

Even though the announcement took place in late April, as indicated above, BMO had
previously engaged an independent firm to conduct a technical review and therefore
apparently knew (since at least mid-February) that there were potential problems with its risk
measurement, valuation and control practices. The results were delivered mid-April, at least
one week before the initial announcement of the losses. It appears that the excessive reliance
on its principal broker quotes to validate and verify the results from their internal mark-to-
market (or better said mark-to-model) values for the natural gas derivatives book played a

1
A portfolio manager that own shares of Bank of Montreal recently said after the bank made public that the
size of the losses were larger than originally thought. “BMO needs to take the time to get the story straight
once and for all. This is not Harry Potter. We don't want any more installments.” See Bloomberg. May 17,
2007. http://www.bloomberg.com/apps/news?pid=20601087&sid=azkH8pjzMNUY&refer=home

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significant role. BMO did not reveal why their risk group did not have an additional series
of checks and balances to ensure that the option prices from their valuation models did not
differ considerably from multiple sources of actual market quotes (the option quotes
provided by Optionable represented the main, and possibly only, check). According to
BMO’s COO (Chief Operating Officer) “In marking to market (the commodities book), or
calculating the market value of the portfolio, the business relied on a single source of
independent quotes and it was slow to introduce multi-contributor quotes”. For yet
unknown reasons, those ‘independent’ quotes appeared to be considerably off the actual
market.

As a result of the losses, a few measures have already been implemented. The main energy
traders involved in the fiasco as well as the former head of the commodities group are no
longer working for the company. BMO recently announced changes in the reporting lines of
the commodity trading portfolio. Further, the risk in BMO’s energy trading book is being
reduced. The bank has also suspended relations with Optionable.

The rating agencies are also keeping a close eye on BMO. For example, S&P indicated that
they are doing a full review of their trading risk management functions. Donald Chu from
S&P said that ``We have the responsibility to put the market on notice that we are
concerned and that we're going out to see them and are doing a more thorough review.''

Surprise

BMO’s losses were a surprise to the bank’s investors as well as regulators since BMO
claimed it had rigorous risk management program in place. For example, if we evaluate the
information in the bank’s annual report for 2006 as well as an investor’s conference call on
March 1st, 2007, then it is instructive to note that there were no indications of the problems
with the commodity trading portfolio. Further, in its 2006 annual report, BMO states that
“the models used to measure market risks are effective at measuring risks under normal
market conditions. In addition, we perform scenario analysis and stress testing on a daily
basis to determine the impact of unusual and/or unexpected market changes on our
portfolios.”

BMO’s Value at Risk (VaR) calculations are shown in Figure 1– referred to as Market Value
Exposure (MVE) for the fiscal year ending October 31st 2006. The market moves in natural
gas during 2007 can not be considered extreme, and therefore, a well designed market risk
model should capture the risk of those positions .Observe, that if the bank’s trading revenue
and VaR measures in Figure 1 are based on risk sensitive trading related revenue and high
quality risk data, then the bank did not experience any one day losses beyond the estimated
MVE numbers in fiscal year 2006. Further, note that actual losses in normal markets are not
expected to exceed the VaR measures at the 99% confidence interval (1% loss tolerance
level) more than 3 times a year (i.e. 1% times 250 trading days in a year)..

Figure 1. Value at Risk for BMO’s Trading and Underwriting Book.

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Source. BMO. Annual Report. Market Value Exposure is a term similar to Value at Risk.
Bank of Montreal uses a 1-day horizon and a 99% confidence level.

Figure 2 reveals that the average and the high daily VaR measure for BMO’s commodities
portfolio in the trading book (for the fiscal year ending October 31st 2006) was C$5.9 million
and C$13.8 million respectively. The C$680 million loss is over 100 times the average VaR
reported for the 2006 fiscal year.

Figure 2. Total Trading and Underwriting Value at Risk (99%, 1 day)

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Source: BMO Annual Report. 2006

VaR has generally proven to be a useful way of assessing the overall risk of trading positions
over a short horizon under “normal” market conditions in financial markets. In effect, the
methodology captures in a single number the multiple components of market risk.
Nevertheless each time there is turmoil, the limitations of even the most sophisticated
market risk measures are revealed. The danger posed by exceptional market shocks are often
accompanied by a drying-up of market liquidity. VaR has also proved unreliable as a measure
of risk over long time periods or in abnormal market conditions.

Energy derivatives experience sharper fluctuations than most other financial derivatives. For
example, the price and volatility dynamics are substantially different. The volatility of FX
rates, interest rates, or equities pales in comparison to the volatility of natural gas or power
prices. In addition, market risk managers face unique additional issues in the gas markets,
such as building the forward gas curve for illiquid hubs.

Explanations

In two recent conference calls2, the CEO, CFO and CRO did not detail the reasons for the
large losses. The conference call showed that the bank’s senior management was not ready to
comprehensively answer many questions about BMO’s natural gas derivatives trading
strategies or to provide insight into the valuation and risk models.

Insufficient checks and balances in the mark-to-market process have been pointed to as the
main culprit. Nevertheless, it appears that there were deficiencies in the bank’s pricing and
risk models in terms of the incorporating the impact of implied volatility changes. The bank
started experiencing heavy losses as implied volatilities came down in the first months of

2
See links for the transcript of the April 27th, and May 23rd 2007 conference calls in the reference section

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2007. The CRO noticed that the risk models had some deficiencies in terms of measuring
the risk of long positions in out-of-them-money (OTM) natural gas OTC options.

The volatility surfaces of natural gas options are characterized by an asymmetric skew (eg
calls are priced at higher volatility levels than comparable puts), and the term structure of
volatilities is highly seasonal. After Hurricane Katrina in 2005, the options markets were
initially pricing another volatile summer for 2006. The level and slope of the volatility skew
exhibited high levels. However, a mild summer and winter 06 seasons brought the level (see
graph with implied volatilities for ATM options in Figure 3) as well as the slope of the
volatility skew considerably down.

BMO’s Chief Operating Officer stated in the May 27 conference call that “The portfolio
contained an unacceptable level of out-of-the-money options, which by their nature are
illiquid, at a time when there was a steep decline in the volatility of natural gas prices.” The
conference call did not comprehensively explore why didn’t alarms didn’t go off earlier to
signal an “unacceptable level” of OTM options.

Figure 3. Implied Volatilities for Prompt-Month Contract for NYMEX natural Gas ATM
Options (April 2006 to April 2007)

Source: Bloomberg May 28th, 2007. Appeared in BMO investor’s call. May 27, 2007

The options that experienced the sharpest percentage decreases in value were the OTM
options. Their market value collapsed when the level and shape of the volatility skew
drastically changed. A risk methodology and pricing model that does not appropriately
incorporate volatility skews would fail to indicate an increasing risk of these OTM options.
In figure 4 we can see a recent implied volatility skew for various OTM calls and puts. We
can see that the levels are considerably lower than those during last year, where implied

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volatilities for at-the-money (ATM) options traded in a range between 80% and 120% for
several months.

Figure 4. Implied Volatility Skew for NYMEX Natural Gas Options (May 1st 2007)
NYMEX Natural Gas Volatilty Skew (May 1st, 2007)
45.00%

44.00%

43.00%

42.00% Prompt Month (June 2007)

41.00%

40.00%

39.00%

38.00%

37.00%
Delta -10 Delta -25 Delta -35 At-the- Delta +35 Delta +25 Delta +10
money

Source: Black Swan Risk Advisors, LLC

The CRO stated in the conference call that “The analysis that we have gone through since
we started to grow this made it clear to us that the VaR methodology in isolation wasn't
going to be adequate for this particular book, which is why we've made some changes.'' The
CRO said that their VaR models indicated an increase in risk in the commodity portfolio,
however, due to the low liquidity of their positions, they could not find a market. The CRO
further stated that “this is a very narrowly traded market and it is difficult to obtain
transparency and price points in that kind of an environment''

In general, VaR and other industry standard risk measures might exacerbate market volatility.
Although it still has to be proven, it is likely that the decrease in option implied volatilities as
well as the drying up of market liquidity may have been caused by the over reliance on VaR
models by energy market participants For example, firms may have to sell off classes of
assets when markets spike and become volatile in order to keep within the VaR limits set by
senior management. This effort to stay within limits depresses market prices even further,
and increases the volatility and correlation of the risk factors for these assets. This, in turn,
might cause another set of firms to hit their VaR limits, forcing them to reduce their
exposure by selling still more of the same assets – perpetuating a vicious circle.

The exit of large OTC derivatives market players in 2006, such as Amaranth and
MotherRock3, probably contributed to the considerable decrease in market liquidity for these
products. In addition, the high market volatility during the summer of 2006 meant that many
firms had to sell part of their options books to remain within their risk limits. Selling
pressure and reduced liquidity for firms that decided to maintain or increase their positions
in the OTC natural gas derivatives markets contributed to lower prices for options.

3
For those readers interested in Amaranth, we recommend Till (2006) and Blanco (2007)

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Most energy trading firms complement VaR with a series of quantitative and qualitative
limits to monitor their market and credit risk exposure. BMO recently upgraded the set of
limits based on the results of a risk review (see Figure 5)

Figure 5. Improved Primary and Secondary Risk Measures for the BMO commodities
portfolio

Primary Risk Measures

• Market Value Exposure (VaR)
• Worst Case Stress Loss
• Delta
• Gamma
• Vega
• Seasonal Tenors (vega & delta)
• Calendar Tenors (vega & delta)
• Daily and Monthly Loss Limits
• Physical Delivery Limits
• Set of Authorized Products
• Counterparty Exposures
Secondary Measures
• Theta
• Sensitivities for NG (NYMEX)
• Sensitivities for Pipeline Regions,
• Sensitivities for Crude Regions
• Notional Outstanding
• Open Interest (Contracts)
• Out of the Money Ratio (OTM %),
• Risk Weighted Assets.

Source: BMO. May 23rd Risk Review.

Proactive (diagnostic) and Reactive (post-mortem) Technical Risk Reviews

BMO conducted an independent risk review. It appears that the review was mostly ‘forensic’
in nature, and did not lead to immediate corrective action that might have reversed the
situation. There are many questions that an independent risk expert should ask in a post
mortem review. However, those questions are most effective when asked ‘before’ a trading
blow up takes place, not after. For example; did the VaR and stress test risk methodologies
properly capture the potential illiquidity of the positions and the potential for large losses? If
the models signaled an increase in the risk of the positions then what did the trading room
do to reverse the situation? If the risk management department escalated the problem then
what did senior management do? How did the response of the trading room and risk
management compare to best practice?

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A proactive or a post mortem assessment of the risk discipline by an independent risk expert
during a significantly sub-par performance of the trading book would call for examining the
degree to which management paid close attention to controlling trading risk. For example,
were risk authorities reduced as losses rose beyond the bank’s tolerance levels? Further, was
their either any violation of any policies (such as trading limits) or defaults across any of the
trading books? Specifically, were there any VaR or stress test market risk authorities that
were exceeded? Did the traders, despite their poor performance, remain focused on
controlling their risk exposures in the face of uncertainties both before and after the public
announcements?

Also, the independent risk expert would ask a series of market related questions. For
example, was the sub-par trading performance primarily traced solely to an erroneous point
of view in the gas markets. How did the broad market gas trading patterns, as well as the
market gas price dynamics skew the familiar trading patterns? Did a change in the normal
number of participants (such as hedge funds, securities firms and banks) change the usual
market dynamics? How did the traders adjust their point of view to the trading patterns and
market price dynamics?

BMO has not yet indicated the intent to make the results of the internal investigation public.
A possible parallel investigation by Office of the Superintendent of Financial Institutions
(OSFI) such as the one conducted by the Australian Financial Regulator after the FX
derivatives losses by National Australia Bank may shed incremental light on the trading loss.

Proactively enhancing the risk management process

Financial services firms should proactively have periodic risk reviews by qualified
independent risk professionals with deep risk experience. A recent approach has been to hire
advisory directors with deep knowledge of the risk space. An advisory director serves in a
variety of roles that encompass assisting management, recommending programs and
reviewing key risk documents. The role also call for advisory directors to familiarize
themselves with high profile businesses and key risk linked reports as well as to educate the
board so that the members can fulfill their responsibilities

The primary role of the advisory director is to assist various senior members of the firm to
fulfill their roles and responsibilities. A connected role is to assist members of the board to
fulfill their governance, risk and compliance (GRC) responsibilities. The role also calls for
recommending in partnership with internal management best practice risk policies,
methodologies and infrastructure. For example, the role calls for recommending best
practices related to market risk (e.g. price risk such as potential of a spike in gas prices),
credit risk (e.g. potential of downgrade risk such as a downgrade in credit rating), operational
risk (e.g. analysis of policies and procedures as well as a system of penalties and incentives
that could lead to people risk, such as potential of a trader committing an illegal transaction) .
This would also include recommending best practice related to business risk, reputation risk,
and strategic risk.

The role also calls for reviewing key documents such as financial records as well as key
controls such as risk control information. An advisory director also needs to become

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familiar with the various books of business (e.g. Gas Book, Gas Options Book, Power
Book, Gas Storage, etc). The role also calls for becoming familiar with the various hedging
and trading strategies (e.g. study the trades in say a “Trading Log”) as well as structured
transactions (e.g. trading physical gas at one location priced at an index for another location).
The advisory director should also become familiar (i.e. stay current) with regulatory practices
(e.g. CFTC, FERC) as well as the practices of external competition. The advisory director
also needs to periodically report findings to the board as well as to provide a Written
Certification with respect to any proposed security filings.

A key role is to participate on either the Audit or Risk Committee of the board as well as
educate these committees on best practice GRC approaches so that they can fulfill their
prescribed roles under the board Charter. The role also calls for the advisory director to
participate on as needed basis at the full board. Typically, the role also calls for participating
in related focused Energy Industry corporate governance and risk related forums (e.g.
PRMIA) as well as to stay current on formal emerging regulatory requirements. (e.g.
Solvency II)

The advisory director should also periodically meet with key personnel to review the risk
program, pricing models as well as internal controls. In the case of BMO, a series of
questions by an experienced independent risk professional on items related to the natural gas
derivatives market might have provided some vale added insights. For example, the
independent risk expert would work in partnership with firm personnel to analyze the energy
derivatives book through asking such questions as:

• What spot and forward models are you using to value natural gas derivatives?
• What is your method to build volatility surfaces for out-of-the-money options?
• Do your pricing models incorporate mean reversion or jumps? Do you truly
understand the model assumptions?
• Are forward curve moves based on one factor or multiple factors? What are those
factors and how are they calibrated to market data?
• Are you using bid-ask spreads when valuing illiquid natural gas derivatives?
• Is the forward curve for illiquid points calculated using multiple reference points (e.g.
brokers, Platts, internal forward curve models…..)
• To what extent are you relying on broker’s valuations?
• Do the internal and external auditors have the skills and experience to conduct
complex valuations of illiquid energy derivatives?
• What are your limits for the options book? Are there specific limits for OTM and
exotic options?
• What is your approach for incorporating the volatility and correlation risk parameters
into the risk and valuation models?
• Are there sufficient model reserves in place for illiquid positions?

Conclusion

, It is self evident that the market’s confidence in a firm’s risk management process will be
highly questioned after a firm suffers a significant derivatives loss. We believe that in order

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to restore confidence, a firm should be transparent about its findings and work to strengthen
any deficiencies in its risk process. For example, a firm might report on where the risk
process was subsequently strengthened in terms of its risk policies, methodologies and
infrastructure, or a combination of them.

As firms expand their energy derivatives trading activities, they would be well served to
establish an advisory director role to ensure that the risk program is tailored to the markets
and instruments they are trading. This effort would serve to reduce the chances of being
seriously exposed to a potential blow-up. If there was a blow-up then an advisory director
can work in partnership with firm personnel to examine and upgrade the risk management
process. The advisory director would review such things as the methodologies used to price
and measure risk as well as the ability to cut large trading losses in a negative market scenario.
A post-mortem analysis will discover many of the deficiencies, but just solving those
problems will not be sufficient. A firm’s risk management culture may need to become more
proactive to avoid being on the front page of the financial newspapers again.

In the coming weeks and months, we would expect to see more comprehensive detail
emerge from investigations into BMO’s natural gas derivatives trading losses. These details
will provide further insight into the effort to upgrade the process to manage risk in the
energy derivatives trading book.

References

Bloomberg. May 17, 2007. Bank of Montreal Raises Trading Loss to C$680 Million

Bank of Montreal. Annual Report. 2006

Bank of Montreal. April 27, 2007 conference call transcript.

http://www2.bmo.com/bmo/files/news%20release/3/1/transcript%20b.pdf

Bank of Montreal. May 23rd Investor Community Conference Call.

http://www2.bmo.com/bmo/files/financial%20information%20slides/3/1/Q207%20Tran
script.pdf

Blanco, C. and Mark, R. (2004) “EWRM for Energy Trading Firms: EWRM starts with Risk
Literacy.” Commodities Now. September 2004.

Blanco, C. and Mark, R. (2004) “Top Ten Questions for Chief Risk Officers at Energy and
Commodity Related Firms: Are you balancing the “hard” vs. the “soft” side of risk management?”
The Risk Desk. End of Year Issue.

Blanco, C., Dowd, K., and Mark, R. (2005) “Russian Roulette” FOW. April.

Crouhy, M., Galai, D. and Mark, R. (2000) Risk Management, McGraw Hill. New York.

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Carlos Blanco, Ph.D. is Managing Director of Black Swan Risk Advisors, LLC
(carlos@blackswanrisk.com), an independent advisory firm with a proprietary approach to
the design, development, and validation of financial risk management programs to global
financial, energy and commodity trading firms. He is also a lecturer on Risk Management at
the University of California, Berkeley.

Robert M. Mark, Ph.D. is the CEO of Black Diamond (bobmark@blackdiamondrisk.com),

which provides corporate governance, risk-management consulting, risk software tools and
transaction services. He was the CRO and Corporate Treasurer at several large financial
institutions. He is also a lecturer on Risk Management at University of California, Berkeley.
He serves on several boards, is the Vice Chair of the Professional Risk Managers’
International Association’s (PRMIA) and the co author of two leading edge books on risk
management

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