These case studies illustrate a number of financial and operational risk management failures. Specifically, we will examine cases involving misleading reporting, large unexpected market movements, and inappropriate customer conduct. Pay close attention to the causes of these financial disasters and how they could have been prevented. You should be prepared to handle questions on these recurring themes.
Drysdale Securities was able to borrow $300 million in unsecured funds from Chase Manhattan by exploiting a flaw in the system for computing the value of collateral.
The head of the government bond trading desk at Kidder Peabody, Joseph Jett, reported substantial artificial profits. After the false profits were detected, $350 million in previously reported gains had to be reversed.
Hidden trading losses at Barings induced Nick Leeson to abandon hedging strategies in favor of speculative strategies. A lack of operational oversight and his dual roles as trader and settlement officer allowed him to conceal his activities and losses.
A currency trader for Allied Irish Bank, John Rusnak, hid $691 million in losses. Rusnak bullied back-office workers into not following-up on trade confirmations for imaginary trades.
UBS’s equity derivatives business lost millions in 1997 and 1998. The losses were mostly due to incorrect modeling of long-dated options and the firm’s stake in Long-Term Capital Management.
Jérôme Kerviel, a junior trader at Société Générale, participated in unauthorized trading activity and concealed this activity with fictitious offsetting transactions. The fraud resulted in $7.1 billion in losses and severely damaged the reputation of Société Générale.
Extreme leverage, a lack of diversification, and inadequate risk models put Long-Term Capital Management in a cash flow crisis when an economic shock created intolerable marked to market losses and margin calls. A forced liquidation of its huge positions drove prices down, further compounding their losses.
The financial crisis at Metallgesellschaft resulted fundamentally from cash flow timing differences associated with the positions making up its hedge. Cash flows on short forward contracts occurred over the distant future. Cash flows on long futures contracts occurred daily. In addition, the sizes of the positions were so large that it prevented the company from liquidating its positions without incurring large losses.
Bankers Trust developed derivative structures that were intentionally complex and prevented Procter & Gamble and Gibson Greetings from fully understanding the trade values and risks that were involved. In taped phone conversations, BT’s staff bragged about how badly they fooled clients.
JPMorgan Chase and Citigroup were the main counterparties in Enron’s derivative transactions. After the Enron scandal was revealed, these investment banks agreed to pay a $286 million fine for assisting with fraud against Enron shareholders.
