FRM Foundations

Allen, Chapter 4: Financial Disasters

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CFA, FRM, CIPM
• Published Mar 10, 2012

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 Allen, Chapter 4:
Financial Disasters

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

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

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

Financial Disasters (Case Studies)

Misleading Unexpected market Conduct of

Reporting moves Customer Business
• Chase/Drysdale • LTCM • Banker’s Trust
• Kidder Peabody • Metallgesellschaft
• Barings
• Allied Irish Bank

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

Chase Manhattan
& Drysdale Securities Chase/Drysdale

• 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)

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

Chase Manhattan &

Drysdale Securities Chase/Drysdale

Key Factors Lessons Learned

• 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.
• More precise methods
required to compute collateral
value
• Need process control: new
products should receive prior
approval “risk function”

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

Kidder Peabody 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)

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

Kidder Peabody Kidder Peabody

Key Factors Lessons Learned

• 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?

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

Barings 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

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

Barings 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

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

Barings Barings

Key Factors Lessons Learned

• Leeson was allowed to settle • Absolute necessity of an
his own trades independent trading back
• Management incompetence office
& poor supervision • Separation of trading and
• Poor reporting settlement functions
• Need to make thorough
inquiries about unexpected
sources of profits and/or cash
movements

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

Allied Irish Bank Allied Irish

• 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

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

Allied Irish Bank Allied Irish

Key Factors Lessons Learned

• Similar to Leeson (internal • Proprietary trading is a high-
deception) risk activity
• Achieved by inventing • Risk management architecture
imaginary trades is crucial
• Relationship between parent
and overseas units needs to be
clarified
• Strong and enforceable back-
office controls are essential

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

Long Term Capital Management (LTCM) 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)

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

Long Term Capital Management (LTCM) LTCM

Key Factors Lessons Learned

• Failure to supplement VaR • Stress scenarios including
with a full set of stress test extreme stresses and
scenarios interaction between market &
• Failure to account for credit risk
illiquidity of positions during • Incorporate liquidity
stress • Initial margin needed if
• (Leverage too high?) counterparty is trader
• (Too much faith in models?) • Greater counterparty
disclosures

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

LTCM: Key factors (con’t) LTCM

LTCM
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

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

LTCM: Key factors (con’t) LTCM

LTCM
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”

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

Metallgesellschaft MG

• 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

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

Metallgesellschaft MG
Metallgesellschaft
Basis risk
Liquidity risk
Operational risk

Shift!

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

Metallgesellschaft MG

Key Factors Lessons Learned

• 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

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

Metallgesellschaft: Key Factors (con’t) MG

Metallgesellschaft
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.

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

Banker’s Trust (BT) 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

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

Banker’s Trust BT

Key Factors Lessons Learned

• 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

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