OPTION MISSES

7.7 OPTION MISSES

In the mid-nineties, media and regulators’ attention was focused on option misses because of huge derivative-based losses that have affected significantly both large corporate firms and institutions. The belief that options are primarily instruments for hedging was severely shaken and the complexity and risks implied in trading with derivatives revealed. Management and boards, certain that derivatives were used only to hedge and reduce price risk, were astounded by the consequences of positions taken in the futures and options markets – for the better and for the worse. According to the Wall Street Journal for 12 April, 1996, J.P. Morgan earnings in the first quarter jumped by 72 % from the previous year, helped by an unexpectedly strong derivatives business that more than doubled the bank’s overall trading revenue! By the same token, firms were driven to bankruptcy due to derivative losses. Business managers also discovered that managing risk with derivatives can be tempting, often only understood by a few mathematically inclined financial academics. At the same time there is a profusion of derivatives contracts, having a broad set of characteristics and responding in different ways to the many factors that beset firms and individuals, which have invaded financial

OPTIONS AND PRACTICE

Table 7.2 Derivatives losses of industries and organizations. Name

Main cause AIG

Losses ($ million)

90 Derivatives revaluation Air Product

Leveraged and currency swaps Arco (Pension Fund)

25 Structured notes Askine Securities

MBS model Bank of America

68 Fraud

Leveraged and currency swaps Barings PLC

Procter & Gamble

Futures trading Barnnet Banks

Leveraged swaps Cargil

Mortgage derivatives Codelco (Chile)

Futures trading–copper Community Bankers

20 Leveraged swaps Dell Computers

35 Leveraged swaps Gestetner

10 Leveraged swaps Glaxo

Derivatives and swaps Harris Trust

52 Mortgage derivatives Kashima Oil

Currency derivatives Kidder Peabody

Fraud trading Mead

12 Leveraged swaps Metalgesellschaft

Futures trading Granite Partners

Leveraged CMOs Nippon Steel

30 Currency derivatives Orange County

Mortgage derivatives Pacific Horizon

70 Structured notes Piper Jaffray

Leveraged CMOs Sandoz

80 Derivatives transactions Showa/Shell Sekiyu

Forward contracts Salomon Brothers

Fraud (cornering) United Services

95 Leveraged swaps Estimated losses

markets. In many cases too, derivatives hype has ignited investors’ imagination, for they provided a response to many practical and real problems hitherto not dealt with. An opportunity to manage risks, enhance yields, delay debt records to some future time, exploit arbitrage opportunities, provide corporate liquidity, leverage portfolios and do whatever might be needed are just a very few such instances.

A derivative mania has generated at the same time their misuse, leading to large losses, as many companies and individuals have experienced. Derivatives became the culprit for many losses, even if derivatives could not intelligently

be blamed. For example, the continuous increase in interest rates during 1993–

94 pushed down T-bond prices so that the market lost hundreds of billions in US dollars. Additionally, the sharp drop in the IBM stock price in 1992–94 from 175 to 50 created a market loss of approximately $70 billion for one firm only! These losses could not surely be blamed on derivatives trading! Table 7.2

199 summarizes some of the losses, assembled from various sources and sustained by

OPTION MISSES

corporate America (Meir Amikam, 1996). These derivative losses were found to

be due to a number of reasons including: (1) a failure to understand and identify firms’ sensitivities to different types of risk and calculating risk exposure; (2) over-trusting – trusting traders with strong personality led to huge losses in Bar- ings, megalomania in Orange County, Gestetner etc.; (3) miscalculation of risks – overly large positions undertaken which turned out sour; (4) information asym- metry – the lack of internal control systems and audits of trading activities has led traders to assume unreasonable positions in hope; (5) poor technology – lack of computer-aided tools to follow up trading activity for example; (6) applying real-time trading techniques, responding to volatility rather than to fundamental economic analysis, that have also contributed to ignoring risks.

Of courser, a number of risk management tools and models have been suggested to institutional and individual investors and traders to prevent these risks wherever possible. For example, value at risk, extremes loss distributions, mark to market and using the Delta of model-based risk, to be considered in Chapter 10, have been found useful. These models have their own limitations, however, and cannot replace the expectations of qualified professional judgement. By the same token, these expectations introduce a systematic risk that can lead to unexpected volatility and cause severe losses, not only to speculators, but also to hedgers. Some of the great failures in 1993–94, for example, were incurred because users were caught by a surprise interest rate hike. A similar scenario occurred when the price of oil dropped. Thus, the use of derivatives for speculation purposes can cause large losses if traders turn out to be on the wrong side of their market expectations.

There are some resounding losses, however, that have been the subject of intense scrutiny. Below we outline a few such losses.

Bankers Trust/Procter & Gamble/Gibson Greeting : ‘Our policy calls for plain vanilla type swaps’, Erick Nelson, CFO, Procter & Gamble.

Procter & Gamble incurred a loss of $157 million loss from interest swaps in both US and German markets, swapping fixed for floating rates. In effect they had a put option given to Bankers Trust. P&G’s strategic error was the belief that exchange rates would continue to fall both in the USA and in Germany. Swaps were thus made for the purpose of reducing interest costs. The actual state of interest rates turned out to be quite different, however. In the USA, the expectation of lower interest rates meant that the value of bonds would increase, rendering the put option worthless to Bankers Trust. In fact interest rates did not fall and therefore, Treasury bonds increased in value, forcing P&G to purchase the bonds from Bankers Trust at a higher price. This resulted in a first substantial loss. By the same token, the expectations of a decline in interest rates in Germany meant that the German Bund would decline rendering again the put option worthless to Bankers Trust. Therefore P&G would have lower interest costs as well. Rates increased instead, and therefore, the value of the German Bund decreased, forcing thereby a purchase of bonds from Banker’s Trust at higher prices then the current market price – inducing again a loss. The combined losses reached $157 million.

OPTIONS AND PRACTICE

In other words, P&G took an interest-rate gamble instead of protecting itself in case the ‘bet’ turned out to be wrong.

In April 1994, Procter & Gamble and Gibson Greetings claimed that Bankers Trust, had sold them high-risk, leveraged derivatives. The companies claim that those instruments, on which profits and losses can multiply sharply in certain circumstances, had been bought without giving the companies adequate warning of the potential risks. Bankers Trust countered that the firms were trying to escape loss-making contracts. P&G sued Bankers Trust in October 1994, and again in February 1995, for additional damages on the leveraged interest-rate swap tied to the yields on Treasury bonds. P&G has also claimed damages on a leveraged swap tied to DM interest rates for $195 million, insisting that the status of the first swap was not fully and accurately disclosed. The case was settled out of court in January 1995. It seemed in the course of the court deliberations that Bankers Trust may have not accurately disclosed losses and Bankers Trust may have hoped that market movements would turn to match their positions, so they did not notify Gibson immediately of the true magnitude of the intrinsic risk of the derivatives bought. Had Gibson been aware of the risk, the losses could have been minimized. In response the bank has fired one manager, reassigned others, and shacked up the leveraged derivatives unit. It also agreed to pay a $10 million fine to regulators and entered into a written agreement with the New York Federal Reserve Bank that allows regulators unprecedented oversight of the bank’s leveraged derivatives business. The agreement is open-ended and highly embarrassed Bankers Trust. In addition, the lawsuits have tarnished the reputation of Bankers Trust. Outsiders have wondered if it was more the deal- making culture that was to blame, rather than the official tale of a few rogue employees. Other banks, such as Merrill Lynch, First Boston and J.P. Morgan have also run into trouble selling leveraged derivatives and other high-risk financial instruments.

The Orange County (California) case was a cause c´el`ebre amplified by the media and regulation agencies warning of the dangers of financial markets speculations by public authorities. The Orange County strategy is called ‘On the street, a kind of leveraged reverse repo strategy, also coined the death spiral because one significant market move can blow down the strategy in one puff’. This can occur if managers fail to understand properly the firm’s sensitivities to different sorts of risks or do not regard financial risks as an integral part of the institution or corporate strategy. Speculation by the Orange County treasurer, who initially generated huge profits, ultimately bankrupted it. As the treasurer supervisor stated: ‘This is a person who has gotten us all millions of dollars. I don’t care how the hell he does it, but it makes us all look good.’

The county lost $2.5 billion. Out of a $7.8 billion portfolio! The loss was faulted on borrowing short to invest long in risk-structured notes. In other words, the county treasurer leveraged the (public) portfolio by borrowing $2 for each dollar in the portfolio, equivalent to investing on margin. The county then used the repo (reverse purchase agreement) market to borrow short in order to purchase

201 long (term) government bonds. In the repo agreement, the county pledged the

OPTION MISSES

long-term bonds it was purchasing as collateral for secured loans. These loans were then rolled over every three to six months. As interest rates began to rise, the cost of borrowing increased while the value of long-term bonds decreased. This situation resulted in a substantial loss. In effect, Orange County was betting that interest rates would remain low or even decrease some and that spreads between long- and short-term rates would remain high. Something else happened. When interest rates rose, the cost of short-term borrowing increased, the value of the long-term bonds purchased decreased, the rates on the inverse floaters (consisting for an initial period of a fixed rate and then of a variable rate) fell and the rates on the spread bonds (consisting of a fixed percentage plus a long-term interest minus a short-term rate) fell as the yield curve flattened. This generated a huge loss for Orange County.

Metalgesellschaft : ‘Pride in integrity takes a blow’ (Cooke and Cramb, Financial Times ). Metalgesellschaft, a $15 billion sales commodity and engineering con- glomerate, blamed its near collapse on reckless speculation in energy derivatives by its New York subsidiary. To save the firm that employed 46 000 people, banks and shareholders provided a $2.1 billion bail-out. The subsidiary MGRM (MG Refining & Marketing) negotiated long-term, fixed-price contracts to sell fuel to gas stations and other small businesses in 1992. The fixed price was slightly higher than the prevailing spot price. To lock in this profit and hedge against rising fuel prices, the company hedged itself by buying futures on the New York Mercantile Exchange (NYMEX). Maintaining such a ‘stacked rollover hedge’ when prices are falling could require large amounts of liquidity. To hedge the long-term contracts, MGRM was obligated to buy short-term futures contracts to cover its delivery commitment since matching its supply obligations with con- tracts of the same maturity was impossible. That strategy was based on rolling over the short-term futures just before they expired. The hedging depended on the assumption that oil markets, which were in backwardation over two-thirds of the time over the past decade, would remain in that state for most of the time. By entering into futures contracts, MGRM would be able to hedge their short positions in the forward sales contracts. This assumption was predicated on the fact that, as expiration approaches, the future price MGRM paid for the contracts would be less than the spot price. That trading and hedging strategy had some inherent risks that happened to be crucial:

r Market fluctuations risk : oil prices, futures and spot price, that did not meet expectations.

r Proper hedge risk : Resulting from mismatched timing of contracts and enter- ing into a speculative hedge.

r Funding risk : futures contracts require marking to market; this margin call caused by futures losses is not offset by forward contract gains, which are

unrealized until delivery.

OPTIONS AND PRACTICE

By September 1993, MGRM’s obligation was equivalent to 160 million barrels. In November 1993, oil prices dropped by $5 to $14.5 as a reaction to OPEC’s decision to cut production. That drop wiped out 20 % of MGRM short-term futures contracts and led to a cumulative trading loss of $660 million. German GAAP does not allow the offset of gains or losses on hedging positions using futures against corresponding gains or losses on the underlying hedge asset, however. Further, Deutsche Bank, advising MG and apprehensive about the short-term losses as they mounted, convinced MG to close out its positions, thus causing the loss. The risk MG was taking was using a short-term instrument hedging strategy for a long-term exposure, creating thereby a mismatch that could be considered

a bet that turned out to be wrong. The paper loss converted into a real heavy loss as the futures positions were closed. In 1994 the group announced that the potential losses of unwinding its positions could bring the total losses up to $1.9 billion over the next three years. It is argued, though, among academics that the strategy could have worked had MGRM not unwound their futures position. Thus, liquidity was essential for this strategy to work. Alternatively MGRM could have reversed its futures position when oil prices dropped. It is important to look at current market conditions in reassessing the merits of one’s strategy. MGRM traders did not (and, in fact, could not) properly hedge. They were speculating on the correlation between the underlying and the cash market. They ignored the risks of a speculative hedge, trusting that they could predict the relationship and changes in prices from month to month.

Barings : ‘Ultimately, if you want to cover something up, it’s not that difficult . . . Derivative positions change all the time and balance sheets don’t give a proper picture of what’s going on. For anyone on the outside to keep track is virtually impossible’ (SIMEX trader, quoted by the Financial Times, February 1995).

The much-publicized Barings loss of $1.3 billion was incurred by its branch in Singapore. It was incurred in three weeks by trading on the Nikkei Index. Leeson the Singapore Office Head of Trading was speculating that the Nikkei Index would rally after the Kobe earthquake, so he amassed a $27 billion long position in Nikkei Index futures. The Nikkei Index fell, however, and Leeson was forced to sell put and call options to cover the margin calls. In an effort to recoup losses, Leeson increased the size of his exposure and held 61 039 long contracts on the Nikkei 225 and 26 000 short contracts on Japanese bonds. When he decided to flee, the Nikkei dropped to 17 885. Leeson was betting that the Index would trade in a range and he would therefore earn the premium from the contracts (to pay the margins). No one was aware of such trades and the risk exposure it created for Barings (as a result, it generated a much-needed and heated discussion regarding the needs for controls. The main office ‘seemed’ to focus far more on the potential gains rather than on the potential losses! This loss induced the demise of Barings, a venerable and longstanding English institution, which was sold to ABN AMRO.

Initially Leeson was responsible for settlement. In a short time he turned out to be a successful trader whose main job was to arbitrage variations among the prices of futures and options on the Nikkei 225, having the unique advantage

203 that Barings had seats both on SIMEX and on OSE (Osaka Stock Exchange).

OPTION MISSES

Contracts on the Nikkei 225 and Nikkei 300 were OSE’s only futures and options and accounted for 30 % of SIMEX business. As a member he enjoyed the privilege of seeing the orders ahead of non-members and of taking suitable positions with low risk. His strategy was mainly based on small spreads in which he invested large amount of money. Later on he was promoted to be responsible for trading and for settlement.

Granite partners : Granite Partners lost $600 million in mortgage derivatives in the mid-nineties. Fund managers promised their investors little risk in their invest- ment policy since they used derivatives mainly for hedging purposes. By using CMO derivatives they expected to take advantage of market movements. But the disclosure emphasized that Granite had the option to wait, if need be, until mar- ket conditions suited the funds’ position. Leveraging with CMO derivatives was much more than what was promised. The portfolio was leveraged based on the assumption of some in-house models. To their detriment, the bond market took

a direction that went against the funds’ positions. Since the portfolio was highly leveraged, the losses grew tremendously and Granite was shut down.

Freddie Mac : In January 2003, PriceWaterhouseCoopers, Freddie Mac’s auditor for less than a year, revealed that the company might have misreported some of its derivatives trades. As a result, Freddie Mac later said that some earnings that should have been reported in 2001 and 2002 were improperly shifted into the future. It is not clear that the top executives were not attempting to distort the company’s books. But recent corporate crises suggest that if someone wants to hide something, derivatives can help (New York Times, 12 June 2003).

Lessons from these loss cases, as well as many others, are summarized in Table

7.3. Generally, the most common cause was speculation – the market moving in directions other than presumed, the trade strategy collapsed – causing unex- pected losses. There is little information relating to internal and external audit and control, however, implying perhaps that in most cases management does not realize the risk exposures they take on and thus controls end up being very poor. There were no reports of written policies that were supposed to limit posi- tions and losses. Had there been such policies, traders could have easily ignored them, trusting their strategic ‘cunning and assessments’. Although these figures were assembled from various sources, including the media, and the actual rea- sons for such losses were varied, a distribution of the main causes for the losses were: management, 18; poor audit or no controls, 20; wrong methods and trade strategies applied, 21; market fluctuation (poor forecasts), 17; and, finally, frauds and traders’ megalomania, 5. Problems associated with audit and controls are resurging in various contexts today. For example, in the wake of multibillion- dollar accounting scandals, companies are under intense pressure to make sure that their financial results do not paint a misleading, rosy picture. Insurance firms for example, are swamped with billions of dollars in corporate bonds that they bought years ago and that are still maintained at their original value in their

OPTIONS AND PRACTICE

Table 7.3 Main reasons which led to losses.

Market Frauds/ Firm

Audit/

Methods/

fluctuations megalomania AIG

+ Air Product

Arco (Pension Fund)

+ Askine Securities

+ Bank of America

Bankers Trust/ Procter and Gamble

+ + Barings PLC

+ Barnnet Banks

Cargil

+ Codelco (Chile)

+ Community Bankers

+ Dell Computers

Gestetner

+ Glaxo

+ Harris Trust

Kashima Oil

+ Kidder Peabody

+ Mead

Metalgesellschaft

+ Granite Partners

+ Nippon Steel

Orange County

+ + Pacific Horizon

+ Piper Jaffray

+ Sandoz

+ Showa/Shell Sekiyu

Salomon Brothers + + United Services

books! Now, financial regulators are suggesting that they should be accounted at their true value, which could lead many insurance firms to the brink, or at the least to reporting huge losses and to borrowing large amounts of money to meet their capital requirements (International Herald Tribune, 17 June 2003, Business Section).