Chapter 9.

Learning From Financial Disasters

 Analyze the key factors that led to and derive the lessons learned from case studies
involving the following risk factors:

 Interest rate risk, including the 1980s savings and loan crisis in the U.S.

 Funding liquidity risk, including Lehman Brothers, Continental Illinois, and Northern
Rock

 Implementing hedging strategies, including the Metallgesellschaft case

 Model risk, including the Niederhoffer case, Long Term Capital Management, and the
London Whale case

 Rogue trading and misleading reporting, including the Barings case

 Financial engineering and complex derivatives, including Bankers Trust, the Orange
County case, and Sachsen Landesbank

 Reputational risk, including the Volkswagen case

 Corporate governance, including the Enron case

 Cyber risk, including the SWIFT case

Analyze the key factors that led to and derive the lessons learned
from case studies involving the following risk factors:
Various risk factors can lead to financial disasters. If ignored, these risk factors can materialize
and escalate to major disasters. The various risk factors and the relevant case studies include:
 Interest rate risk – The Savings and Loan Crisis
 Funding Liquidity risk – Lehman Brothers, Continental Illinois, Northern Rock
 Hedging Risk – Metallgesellschaft
 Model Risk – Niederhoffer, LTCM, The London Whale
 Corporate Governance - Enron
 Rogue Trading and Misleading Reporting – Barings
 Risk of using complex derivatives – Orange County, Sachsen
 Reputation Risk – Volkswagen Scandal
 Cyber Risk - SWIFT

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Interest rate risk, including 1980s savings and loan crisis in the U.S.
Interest rate risk has emerged during the last century as a major risk responsible for firm failures
in the financial services sector. The fall of the U.S. Savings and Loan crisis in the 1980s is a
significant example.

Firms must mitigate interest rate risk by managing the asset-liability mismatch on their balance
sheet. The effect of interest rate movement on assets must be highly correlated to interest rate
movement effect on liabilities even during high volatile interest rate environments. This can be
partially done using duration matching tools or sophisticated derivative products such as caps,
floors, and swaps.

The Savings and Loan Crisis

The United States Savings and Loan industry prospered mainly because of two factors:

 Regulations related to interest paid on deposits (i.e., regulation Q)

 Upward sloping yield curve: S&Ls borrowed at short-term maturity savings and term
deposits and lent typically as a ten-year residential mortgage. In banking industry terms,
S&Ls simply had to "ride the yield curve" to make profits.
Inflation in the late 1970s rose, leading Fed to implement a restrictive monetary policy. This led
to a significant rise in interest rates. The funding costs for S&Ls rose because there was an
increase in the short-term rates (the main source of funding for S&Ls). It led to negative net
interest margins on many of the long-term residential mortgage portfolios.

To improve their balance sheets, S&Ls started with new businesses that had higher margins but
riskier lending. However, the industry lost more money due to poor credit controls and business
risks. About one-third of S&Ls failed during 1986 and 1995. Finally, the industry was supported
by one of the world's most expensive banking system bailouts of $160 billion, fully funded by the
American taxpayers.

Funding liquidity risk, including Lehman Brothers, Continental

Illinois, and Northern Rock
Funding liquidity risk is the risk that the bank cannot fund its liabilities. Such risk can arise due to
external market conditions or the bank's own Balance sheet problems. Generally, it is the
combination of both that causes the collapse of the firm. The collapse of Bear Stearns, Lehman
Brothers, and the Long-term Capital Management (LTCM) are examples of funding liquidity
crises caused due to both the external market conditions and the issues with the bank's inherent
Business model.

4
Liquidity Crisis at Lehman Brothers

Facts
 Lehman Brothers was a 150-year-old Investment bank that invested heavily in the
securitized U.S. real estate market during the 1990s and early 2000s.
 The bank sold mortgages to residential customers, converted the loan portfolios into
high rated securities, and then sold these securities to investors.
 In 2006 real estate market in the U.S. saw a decline in housing prices after a year-long
boom.
 The bank increased the amount of mortgage-related assets for its own account and
started making outsized bets on U.S. commercial real estate as well.
Key factors:
 While the bank's business model was risky, its leverage ratio and funding strategy turned
the investment position into a disaster. In 2007, the bank had an asset to equity ratio of
nearly 31:1. The bank borrowed short-term funds (e.g., daily borrowing from repo
markets) to make long term illiquid real estate investments.
 The U.S. housing bubble burst in the second half of 2007, and the subprime mortgage
market was in deep trouble. Lehman Brothers and other highly leveraged firms with
investments into subprime securities started to lose confidence. In March 2008, Bear
Sterns (a highly leveraged bank) collapsed, and J.P. Morgan bought it at one-tenth of
the prior market value.
The final collapse
 In the following month after the collapse of Bear Sterns, investors started questioning the
accuracy of the value of Lehman's real estate assets. The bank's counterparties started
to lose confidence and demanded more collateral, began reducing their exposure, and
some refused to deal with the bank.
 On September 15, 2008, Lehman Brothers filed for bankruptcy after failed attempts for
funds or a larger bank sell-off.

Liquidity crisis at Continental Illinois

Continental Illinois Bank is an example of funding liquidity risk created by internal credit portfolio
problems and exacerbated by weaknesses in its funding strategy.

Facts:
 Continental Illinois was once the largest bank in Chicago.
 The bank pursued an aggressive growth strategy in the late 1970s, which saw a great
jump in its commercial and industrial lending from $5 billion to $14 billion in 5 years.
 The bank's assets grew from $21.5 billion to $45 billion during the same time.
 A small Bank, Penn Square, closed down in 1982. Penn Square issued loans to oil and
natural gas companies during the boom period of the late 1970s.
 Being a small Bank, Penn Square would pass on large loans to big banks like
Continental Illinois.

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Key factors:
 The oil and gas prices declined after 1981, and firms began to default, leading to a
closedown of 1982.
 Continental Illinois had an exposure of $1 billion to Penn Square's oil and gas
customers, which suffered huge losses due to defaults.
 Making things worse, Continental had tiny retail banking operations and small amounts
of core deposits. It used federal funds and large issues of certificates of deposit to fund
its lending business.
 It became difficult for Continental to fund its operations from U.S. markets. The bank
started raising funds at a higher rate in the foreign money markets like Japan.
 However, rumors about the Banks worsening financial condition made foreign investors
withdraw their deposits. The investors withdrew $6 billion in only ten days.
 The bank fell into a deep liquidity crisis before the regulators stepped in to prevent other
banks from a domino effect.

Northern Rock—Liquidity and Business Models

The failure of Northern Rock in 2007 is a recent example of a liquidity crisis caused due to
structural weakness in the bank's business model. The crisis was caused due to a combination
of two factors – excessive use of short-term financing for long term assets and loss of market
confidence.

Facts:
 Northern Rock was a medium-sized bank in the U.K.
 The bank was fast-growing its assets at around 20% per year by specializing in
residential mortgages.
 The bank expanded aggressively into the first quarter of 2007.
 The bank followed an originate-to-distribute approach, which was unusual among U.K.
banks.
 The bank raised money through securitizing mortgages, selling covered bonds, and
using wholesale funding markets for funds.

Key Factors
 The bank used funds from continental Europe, America, and the U.K. to mitigate
possible weaknesses in its funding strategy. However, it overestimated the benefits of
geographical diversification.
 As the defaults rose in the subprime mortgage in the U.S. in 2007, it spread to
institutions with investments in asset-backed securities and finally to interbank markets.
 The interbank funding market froze in August 2007, and Northern Rock suffered from
funding itself through interbank loans.
 There was a run on deposits between September 14 and September 17, and finally, the
U.K. authorities provided support to the bank and took over the control.

6
Implementing hedging strategies, including the Metallgesellschaft
case
Hedging should be a benefit but can also be a challenge. Hedging strategies require relevant
statistical tools and information, including market data and corporate information. It requires
appropriate models to be used for pricing and hedging. The tools are sometimes built in-house
but mostly outsourced from a vendor along with data used for modeling, estimation, and
hedging process. The risk management function should have a deep understanding of the
proper use and limitations of the tools, whether built in-house or sourced from a vendor).

There are two types of hedging strategies:

 Static: Static strategy is easier to implement and monitor than a dynamic strategy. A
hedging instrument similar to the position is purchased and held usually for the same
time as the underlying position.
 Dynamic: Dynamic strategy involves adjustments to hedged positions by continuous
trading. It requires changing the hedged position accordingly as the exposure in the
underlying position changes. Dynamic strategy requires greater managerial effort to
implement and monitor and higher transaction costs.

Metallgesellschaft (aka, “MGRM”) – Dynamic Hedging strategy gone wrong

The MGRM case shows the discrepancy between economic hedging and accounting hedging. It
further highlights the differences between hedging the P&L and hedging the cashflows. MGRM
was fully hedged in economic terms but was completely exposed in accounting terms and
therefore failed due to illiquidity.

Facts

 MGRM wrote long-term (forward) contracts to supply customers with gas and oil
products at fixed costs; MGRM hedged these contracts with short‐term gas and oil
futures.
 Spot oil prices fell significantly in 1993, which required MGRM to pay in cash for its long
futures positions. Although MGRM had unrealized economic gains on the short forward
contracts to customers, this resulted in a temporary negative cash flow.
 MGRM's parent company did not expect negative cash flows, and when asked for
funding of around $ 900 million,
the parent company ordered all
the hedges to be liquidated in
December 1993. This increased
unhedged exposure to gas and oil
prices through customer contracts,
which were unwound at
unfavorable terms.

7
Key Factors

 The first factor was the market shift to contango (futures prices exceed the spot price)
that exploited the basis risk. The stack-and-roll hedge was exposed to basis risk. The
shift to contango created losses on roll return; this greatly increased the cost of the
stack-and-roll hedge. In turn, this led to cash flow (liquidity) problems.
 The second factor was the German accounting rules that required Metallgesellschaft
to realize futures losses immediately (as the hedge instruments) but did not allow it to
recognize unrealized gains on the underlying forward contracts with customers

Accounting standards required recognition of futures losses but not forward gains! These
reported losses triggered margin calls and a panic, which led to credit rating downgrades.

Lessons learned

 If a market maker's strategy is to extend liquidity in a market by using short-term hedges

against long-term contracts, proper risk controls must be applied
 Especially in a stack-and-roll hedge, the roll yield (aka, roll return) associated with
futures contracts is a key risk that requires valuation reserves
 Running short-term hedges against longer-term risk requires flexibility in assessing the
trade-offs between risk and reward.

8
Model risk, including the Niederhoffer case, Long Term Capital
Management, and the London Whale case
Model risk

Sophisticated financial products and derivatives use valuation models to determine the price.
Institutions are prone to model risk while valuing these products. Model risk is a common risk
and difficult to detect. It can rise due to:
 Use of incorrect model
 Incorrectly specifying a model
 Use of insufficient data
 Use of incorrect estimators
 Use of flawed underlying assumptions

Wrong Assumptions—The Niederhoffer Put Options

Facts:
 Victor Niederhoffer ran a successful hedge fund with a strategy to write uncovered deep
out of the money put options on the S&P 500 Index.
 Since the options were deep out of the money, the premiums were quite small.
 He had an assumption that the market will not decline more than 5% in one-day. A fall of
5% was virtually impossible if the market returns were normally distributed.
 However, the strategy failed when the stock market fell by over 7% in one day in
October 1997.
 The fall in U.S. equity prices followed a decline in the Hang Seng Index, which resulted
in a fall in Asian markets.
 Liquidity in the markets dried up.
 The fund's brokers sold Niederhoffer's positions for pennies because of his failure to
meet margin calls of over $50 million and effectively wiping out the fund's equity.
Key Factors:
 There was an underlying flaw in the strategy as the strategy earned small profits over a
period of time with a small probability of a major loss.

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Long Term Capital Management (LTCM)

Facts

Long-Term Capital Management (LTCM) hedge fund's

positions were daily marked to market (M2M). All the
market values were provided by the suppliers, and there
was the accusation of fraud or misleading information. The
LTCM failed due to large market moves.

From 1994-1998, LTCM had great returns with arbitrage type trades. The LTCM was taking the
following types of positions:
 LTCM was a long U.S. interest rate swap and short U.S. government bonds when the
spreads between them were at historically high levels. This position will profit if the
average spread between the London Interbank Offered Rate (LIBOR) at which swaps
are reset and the repurchase agreement (R.P.) rates at which government bonds are
funded not higher than the spreads at the time of entering the trade. In a long time
period, the range of LIBOR-RP spreads is not wide, but in the shorter tenure, the swap
spreads can have large swings. These large swings can be due to investors' demand for
the safety of government bonds as compared to the high yield of corporate bonds
(corporate bond issuers demand interest rate swaps to convert fixed debt to floating
debt).
 LTCM used to write options when the implied volatility was historically high. In the long
run, the position will make money if the actual volatility is lower than the implied volatility;
however, in the short term, the implied volatility may increase due to investors'
preference for safeguard against the stock market crashes.
For high returns, LTCM needed to finance positions for longer terms. This was because they did
not want to close the position before it has reached the favorable price. LTCM would not have a
crisis if some of the trades were in its favor and others were not. However, if most of the trades
moved against LTCM, it would need to raise cash.

And this is what happened in the second half of 1998! Two events unfolded together – Russia
defaulted on its debt in August, and Salomon Brothers in June 1998 decided to liquidate their
proprietary positions, which were similar to that of LTCM's position. These both events resulted
in a rapid deterioration of LTCM's positions. Finally, LTCM was funded with a fresh equity
investment of $3.65 billion by 14 of the largest creditors.
Key Factors

 LTCM's leverage was too high

 LTCM did not adequately stress test their models; i.e., model risk may be the defining
features of the LMCM case study
 Stress test scenarios could not supplement VaR
 LTCM failed to account for illiquidity during stress periods

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Lessons learned (according to Steve Allen)1

 A stress scenario is needed to look at the impact of a competitor holding similar

positions exiting the market, as when Salomon decided to cut back on proprietary
trading. Also, stress scenarios, including extreme stresses and interaction between
market & credit risk, are required.
 To incorporate liquidity and initial margin needed if the counterparty is a trader
 Greater counterparty disclosures

Additional lessons learned (according to Reto Gallati; previously assigned author):2

 Model risk: Risk models that relied on normal distribution and extrapolation of historical
returns—did not handle the once-in-a-lifetime event. Risk models did not handle
correlations that spiked during a crisis event
 Funding liquidity risk: When the firm lost nearly half its value in a sudden plunge, the
lack of equity capital created a cash flow crisis
 Diversification: Market risk: Extreme leverage combined with concentrated market
risk—LTCM had a balance sheet leverage of 28-to-1
 Marking to market. "Conflict between hedging strategies and cash requirements."
 Liquidity squeeze: Asian crisis → Brazil devalue currency → Flight to quality →
Spreads increase → 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."

Further suggestions by CRMPC3

The Counterparty Risk Management Policy Group (1999) made suggestions for improved
practices, many of which are based on the case of LTCM:
 A greater reluctance to allow trading without initial margin for counterparties
whose principal business is investing and trading. A counterparty with other
substantial business lines—for example, auto manufacturing or retail banking —is
unlikely to have all of its economic resources threatened by a large move in financial
markets. However, a firm primarily engaged in these markets is vulnerable to illiquidity
spreading from one market to another as firms close out positions in one market to meet
margin calls in another market. For such firms, an initial margin is needed as a cushion
against market volatility.

1 Steve Allen, Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk, 2nd Edition

(New York: John Wiley & Sons, 2013)

2 Reto Gallati, Risk Management and Capital Adequacy (McGraw-Hill Education; April 11, 2003)
3 Counterparty Risk Management Policy Group Report: Hearing Before the Subcommittee on Capital Markets,

Securities, and Government Sponsored Enterprises of the Committee on Banking and Financial Services, U.S.
House of Representatives, One Hundred Sixth Congress, First Session, June 24, 1999, Volume 4

11
  Factoring the potential costs of liquidating positions in an adverse market
environment into estimates of the price at which trades can be unwound. These
estimates should be based on the size of positions and the general liquidity of the
market. These potential liquidation costs should impact estimates of the amount of credit
being extended and requirements for the initial margin.
 A push for greater disclosure by counterparties of their trading strategies and
positions. Reliance on historical records of return as an indicator of the volatility of a
portfolio can be very misleading because it cannot capture the impact of changes in
trading style.
 Better use of stress tests in assessing credit risk. A major emphasis is better
integration of market risk and credit risk stress testing to account for the overlap in risks.
In the LTCM case, this would have required recognition by a creditor to LTCM that many
of the largest positions being held by LTCM were also being held by other investment
funds to which the firm had counterparty credit exposure, as well as by the firm's own
proprietary traders. A full stress test would look at the losses incurred by a large market
move and subsequent decrease in liquidity across all of these similar positions.

Model Risk and Governance – The London Whale

In 2012, J.P. Morgan Chase lost billions of dollars from exposure to a massive credit derivatives
portfolio in its London office. The key facts include:
 JP Morgan Chase (the largest U.S. financial holding company with $2.4 trillion in assets)
was also the world's largest derivatives dealer and the largest single participant in credit
derivatives markets.
 In 2006, the CIO approved a proposal to trade in synthetic derivatives, a new trading
activity called the Synthetic Credit Portfolio (SCP). In early 2012, the bank's Chief
Investment Officer (CIO) placed a huge bet on a complex set of synthetic credit
derivatives that lost at least $6.2 billion in 2012.
 The CIO's losses resulted from the so-called "London Whale" trades executed in the
London office. These large trades roiled world credit markets. Although initially
dismissed CEO, the losses quickly doubled and then tripled (despite a relatively benign
credit environment).
 In 2012, when asked to reduce the risk-weighted assets, the CIO instead launched a
trading strategy that purchased long credit derivatives to offset its short derivatives
positions and lower the CIO's RWA.
 The trading strategy not only ended up increasing the portfolio's size, risk, and RWA but
also, by taking the portfolio into a net long position, eliminated the hedging protections
the SCP was originally supposed to provide.

12
Operational Risk

The CIO established the daily value of credit derivatives by marking at or close the median price
in the daily range of prices (bid-ask spread).
 However, later the CIO began to assign more favorable prices within the daily price
range to its credit derivatives. This enabled them to report smaller losses in the daily
P&L reports that the SCP filed internally with the bank.
 This resulted in different values to identical derivatives holdings by the CIO and the
Investment Bank (which used Independent price services to identify the midpoints in the
relevant price ranges) and resulted in collateral disputes with counterparties.
 After directions from the Deputy Chief Risk Officer, the CIO had to mark its books in the
same manner as the investment bank, thus putting an end to mismarking.

Corporate Governance: Poor Risk Culture

 The risk limit breaches were routinely disregarded, risk metrics were criticized and
downplayed, and risk evaluation models were targeted by bank personnel seeking to
produce artificially lower capital requirements.
 The CIO used five key metrics and limits to gauge and control the risks associated with
its trading activities, including Value-at-Risk (VaR).
 The SCP's breaches were routinely reported to the bank and CIO management, risk
personnel, and the traders, which were largely ignored and did not require an in-depth
review of the SCP or immediate remedial action to lower the risk. However, it ended up
raising the relevant risk limit.

Model Risk: Fudging VaR Models

 To downplay the risk of credit derivatives and proposing risk measurement, an

alternative CIO model was adopted while CIO was in breach of its own and bank-wide
VaR limit. The new model lowered the SCP's VaR by 50%.
 The CIO engaged in substantially more-risky derivatives trading. However, months later,
the bank realized that the model is improperly implemented and required error-prone
manual data entry, thus revoking the new VaR model.

13
Rogue trading and misleading reporting, including
the Barings case
Barings Case

The Barings Bank lost roughly $1.3 billion from 1993 to 1995. The loss
was due to unauthorized trades of junior trader Nick Leeson. The bank was forced into
Bankruptcy in February 1995 due to losses incurred by the bank and potential additional losses
on outstanding trades.

Key Factors
 Leeson was supposed to run low-risk limited return arbitrage trades. Instead, he was
taking large speculative positions in Japanese stocks and interest rate futures and
options. The speculative positions were taken on behalf of fictitious customers.
 Leeson reported profits in his own accounts by booking losses in the non-existent
customer accounts. This earned him a bonus of over $700,000 in 1994.
 Leeson exploited his knowledge of weaknesses in the firm's controls to create false
accounts. Still, his exploitation stupendous incompetence by Barings' management
enabled his exploits: they ignored every known control rule and failed to act on
several red flags. Amazingly, his trades were executed in exchange‐traded markets that
require immediate cash settlement of all positions, limiting his ability to hide positions.
 Management also allowed Leeson to be head of trading and the back office at an
isolated branch at the same time. The management ignored the warnings in auditors'
reports about the dangers of allowing Leeson to settle his trades.
 Management failed to ask about the huge profits generated by low-risk trading
strategies. This can also be attributed to the very poor management information
systems (MIS). Different risk reports provided different information.
The size of losses Leeson was trying to cover up eventually got too overwhelming, and he took
flight, leaving behind the admission of irregularities. Eventually, Leeson could not cover up the
growing number of losses and fled.

Lessons learned (according to Steve Allen)4

 Absolute necessity of an independent trading back office
 The need to make thorough inquiries about unexpected sources of profit
 Need to make thorough inquiries about any large unanticipated movement of cash.

4 Steve Allen, Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk, 2nd Edition

(New York: John Wiley & Sons, 2013)

14
Financial engineering and complex derivatives, including Bankers
Trust, the Orange County case, and Sachsen Landesbank
Financial engineering employs financial products (especially forward, swaps and options).
These products are meant to hedge specific risks or to satisfy client needs.

Derivatives can be used to segment risks or to manage risks jointly. For example, a U.S. fund
manager holding a euro-denominated bond is exposed to both interest rate risk in the euro fixed
income market and the currency risk from fluctuations in the dollar/euro exchange rate. The
manager can hedge both the interest rate and currency risk through a cross-currency swap. The
manager can alternatively choose to hedge the foreign exchange exposure separately through a
currency forward or option. The fund manager can enter into a quanto swap through which he
can hedge only the currency exposure. In a quanto swap, the fund manager will receive the
coupon of the bond at a predefined exchange rate and pay the U.S. Libor floating rate.

Financial engineers devise such complex instruments to satisfy the risk appetites of their clients.
Financial engineering can also be used for speculation by entering into complex transactions to
earn immediate returns. However, this involves an unlikely risk of potential severe future losses.
Sometimes these complex instruments are not fully understood by the firms or are not fully
communicated to the senior managers or other stakeholders.

The Bankers Trust

Facts
 In 1994 Procter & Gamble (P&G) and Gibson Greetings
sued Bankers Trust. P&G and Gibson had suffered huge derivatives losses in trades
done by B.T. They claimed that B.T. had misled about the nature of the positions. The
trades had very little market or credit risk as the market risk was hedged with other
derivative positions, and there was no credit counterparty risk.
 During the legal process, the uncovered evidence damaged B.T.'s reputation for fair
business dealing. The CEO resigned, and the bank was forced into acquisition by
Deutsche Bank.
Key Factors
 Complex derivatives: The trades done by B.T. had a small, likely reduction in funding
expenses for P&G and Gibson in exchange for a potential large loss under less probable
circumstances. P&G and Gibson were executing these trades for several years before
1994 and had good results. However, the trades' complexity was such that B.T. should
have explained the payoff structure to the clients.
 The structure did not meet the clients' needs but was "tailor-made" as complex so that
the clients cannot compare the pricing from other competitors. This also made P&G and
Gibson highly dependent on B.T. as they could not get competitive quotes to unwind
their positions.
 Evidence of intent to deceive (Discovery evidence): The lawsuit discovered an
internal conversation in a phone recording where the B.T. staff boasted of fooling the
clients about the true value of the trades and the little understanding of the clients about
the true risks involved in such trades. The recordings further showed that the price
quoted was manipulated by B.T. to mislead the clients.

15
Lessons to be learned (according to Steve Allen)5

 Firms should tighten procedures for dealing with customers, both in 1. better controls to
match the degree of trade complexity with customer sophistication, and 2. Offer a way
for customers to acquire price quotes from an area independent of the front office.
 Any form of communication that can later be made public should be treated with caution.
B.T.'s reputation was already hurt by the objective facts of its conduct. Still, it was even
further damaged by the arrogant and insulting tone some of its employees used in
referring to clients, which could be documented through recorded conversations.

The Case of Excess Leverage and Complex Financial Instruments: Orange County

Leverage can significantly impact a firm's earnings. Leverage multiplies profit or loss. Investors
can finance a major part of their investments with borrowed money using Repos. California's
Orange County also used leverage through the use of repos.

Facts:
 In the early 1990s, Robert Citron, a trader with Orange County, borrowed $12.9 billion
through the repo market. He accumulated securities worth $20 billion, although the fund
had invested assets of only $7.7 billion. He invested the borrowed funds into complex
inverse floating-rate notes. The inverse floating-rate notes coupon payment decline if
interest rates rise. In the years before 1994, Citron made 2% more than comparable
funds invested in similar pools of assets.
 However, as the fed increased the rates by 250 basis points, the market value of such
securities dropped, incurring a loss of $1.5 billion by December 1994.
 The funds' lenders stopped rolling over of repos, and Orange County had to file for
bankruptcy.
Key factors:
 Orange County failed due to the use of excessive leverage and risky interest-rate bets.
 Citron admitted he did not understand the risk exposure of the fund due to the positions.
Lessons learned:
 Firms need to understand the inherent risks in their business models.
 Senior management should deploy robust policies and risk measures. The risk appetite,
use of derivatives, and overall business strategy of the firm should be well
communicated to all the stakeholders.
 Management and the Board should look for hidden risks in the firm and understand
when they can produce losses for the firm.

5 Steve Allen, Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk, 2nd Edition

(New York: John Wiley & Sons, 2013)

16
The Case of Investing in AAA Tranches of Subprime CDOs: Sachsen

 Before the 2007-2009 financial crisis, European Banks were the biggest buyers of U.S.
subprime securities, including publicly owned German Bank, the Leipzig-based Sachsen
Landesbank.
 Saschen set up vehicles to hold U.S. mortgage-backed securities through a unit in
Dublin. The vehicles were off the balance sheet of the parent but had the guarantee of
the parent bank, Saschen.
 The bank was traditionally specialized in regional lending operations, mainly to small and
medium-sized companies. The MBS required good understanding and pricing expertise.
 The operations at the unit were highly profitable but too large compared to the balance
sheet of Sachsen.
 During the crisis of 2007-2009, the entire capital of Sachsen bank was wiped out, and it
was finally sold to Landesbank Baden- Württemberg (i.e., another German state bank).

Reputational risk, including the Volkswagen case

Reputational risk is the risk of damage to a firm's reputation for unethical conduct. Most
companies are under pressure to maintain their reputation as an ethical organization committed
to environmental, social, and governance (ESG) related best practices.

Volkswagen Emission Cheating Scandal

Facts:
 Volkswagen is a German automaker that was hit by a major scandal.
 In September 2015, the United States Environmental Protection Agency (EPA)
announced that Volkswagen deceived the regulators on emission controls in its diesel
engines.
 The company programmed its emission controls to work only during the regulatory
testing but not during real-world driving. The company had put this programming to over
ten million cars worldwide from 2009 to 2015.
 The deception was formally acknowledged by the company in a September conference
call with the EPA and California officials.

The Multi-Faceted Costs of This Scandal

The scandal made significant damage to the company

 The company’s share price fell by over a third
 Firm faced billions of dollars in fines and penalties
 Numerous lawsuits were filed, and the firm's reputation took a severe hit
 Gorman government officials were concerned that the value of "Made in Germany"
would itself be diminished because of the Volkswagen scandal.

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Corporate governance, including the Enron case
Enron: Facts

 Enron was formed in 1985 following the heavily leveraged merger of

Internorth and Houston Natural Gas. Enron pushed for deregulation of
the energy market to gain flexibility in its business model. Enron
played a major role in the 2000-2001 California electricity crisis.
 Due to market manipulations in electricity supply, California was
having an electricity shortage. Hence, it capped the retail electricity
prices. Enron would close the power plants during peak demand, raising the power
prices up to 2,000%. After California capped the retail electricity prices, revenue margins
across the industry dropped due to Enron's actions. This led to the bankruptcy of one of
the largest Power Companies in the U.S. – Pacific Gas and Electric Company in 2001.
 Enron also failed but due to its poor corporate governance and risk management. Enron
went bankrupt in December 2001 and was one of the largest corporate bankruptcy in
history at that time.
 Enron was prone to agency risk - Many in Enron's senior management acted in their own
self-interest and against the interests of shareholders.
 Enron's board also failed to fulfill its fiduciary duties to the shareholders. For example,
The Board allowed the CFO to be the sole manager of a private equity fund that did
business with Enron. The fund lacked economic substance.
 Enron used fraudulent accounting practices to hide its actual financial performance.
Enron would transfer its stock to a special purpose vehicle (SPV) and receive cash or
notes in exchange. SPV had Enron stock as its asset on the balance sheet, and Enron
guaranteed the SPV's value to reduce its credit risk. Enron did not disclose the
relationship between the company and the SPV.
 Enron used another deceptive accounting practice – market to market. Enron would
declare projected mark-to-market profit on its financial statements on a physical asset
that is yet to produce real cashflows. However, if the revenue earned from the asset was
less than the projected amount, Enron transferred the asset to an SPV, thereby
hiding/not reporting the loss. Enron simply wrote off unprofitable assets without even
impacting the bottom line.
 Enron's books were audited by Arthur Andersen (one of the Big Five accounting firms at
that time). However, Andersen either did not catch or failed to report the fraudulent
accounting practices followed by Enron. However, once the Enron scandal burst,
Andersen was forced to surrender its accounting licenses and close down.

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Aftermath the Enron Scandal

Major changes took place after the Enron Scandal

 Sarbanes-Oxley Act, 2002 was formed
 Changes in stocks exchange and accounting rules
SOX established the Public Company Accounting Oversight Board (PCAOB) to promote good
corporate governance and financial disclosure.
The Chief Risk Officer helps integrate corporate governance responsibilities with existing risk
management responsibilities to improve overall risk governance.

Cyber risk, including the SWIFT case

Cyber risk is critically important for banks these days. Banks are prone to various cyber risks
like
 Banks' systems can be hacked
 ATMs can be used to steal money and client information
 Customer identities can be stolen and misused
Financial institutions spend billions of dollars to save their data and systems from the outside
world and internal misuse. Major regulatory bodies like Bank for International Settlements (BIS),
International Monetary Fund (IMF), and local regulators are concerned about the cyber threats
to the banking system.

The SWIFT Case

Facts:
 SWIFT is the worlds' leading system for the electronic transfer of funds among banks.
 It processes billions of dollars in transactions every day, and usually, the transactions
are completed in seconds.
 The New York Times published an article n April 2016 that revealed the use of the
SWIFT network to steal $81 million from an account of Bangladesh Bank (central bank
of Bangladesh) at the New York Fed.
 Malware was used to send an unauthorized SWIFT message for the transfer of funds to
the hacker's account, and then the malware deleted the database record of the transfer
and disabled the transaction confirmation messages.

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