On December 2, 2001, Enron Corp., at the time the world's largest energy trading company, declared bankruptcy, causing a loss of $11 billion dollars for its shareholders and billions more for its trading counterparties. At the time, it was the largest bankruptcy filing in US history. As events unfolded and the investigations took place, it was revealed that there were several "off-sheet," "paper" companies churning-out false earnings. These were "mark-to-market," unrealized earnings, that had no cash gains associated with them. Ultimately, it was a lack of controls, or a failure to adhere to them, that allowed this to occur. Top executives at Enron were convicted and sent to prison, and their outside auditors, Arthur Andersen, would go out of business.
In this lesson, we will learn about other famous cases where financial disasters took place due to a lack of controls and oversight. We will explore concepts such as "mark-to-market," and "value at risk," both financial risk measures that are mandatory for today's publicly-traded energy companies who deal in financial derivatives.
At the successful completion of this lesson, students should be able to:
This lesson will take us one week to complete. The following items will be due Sunday at 11:59 p.m. Eastern Time.
If you have any questions, please post them to our General Course Questions discussion forum (not email), located under Modules in Canvas. The TA and I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.
Seng - Chapter 11
Read the three case studies on the following pages before viewing the lecture.
In February 1995, Nick Leeson, a “rogue” trader for Barings Bank, UK, single-handedly caused the financial collapse of a bank that had been in existence for hundreds of years. In fact, Barings had financed the Louisiana Purchase between the US and France in 1803. Leeson was dealing in risky financial derivatives in the Singapore office of Barings. He was the lone trader there and was betting heavily on options for both the Singapore (SIPEX) and Nikkei exchange indexes. These are similar to the Dow Jones Industrial Average (DJIA) and the S&P500 indexes here in the US.
In the early 90s, Barings decided to get into the expanding futures/options business in Asia. They established a Tokyo office to begin trading on the Tokyo Exchange. Later, they would look to open a Singapore office for trading on the SIMEX. Leeson requested to set up the accounting and settlement functions there and direct trading floor operations (different from trading). The London office granted his request and he went to Singapore in April 1992. Initially, he could only execute trades on behalf of clients and the Tokyo office for "arbitrage" (Lesson 10) purposes. After a good deal of success in this area, he was allowed to pursue an official trading license on the SIMEX. He was then given some "discretion" in his executions, meaning; he could place orders on his own (speculative, or "proprietary" trading).
Even after given the right to trade, Leeson still supervised accounting and settlements. There was no direct oversight of his "book" and he even set up a "dummy" account in which to funnel losing trades. So, as far as the London office of Barings was concerned, he was always making money because they never saw the losses and rarely questioned his request for funds to cover his "margin calls" (Lesson 3). He took on huge positions as the market seemed to "go his way." He also "wrote" options, taking on huge risk (Lesson 10).
He was, in fact, perpetuating a "hoax" in his record-keeping to hide losses. He would set the prices put into the accounting system and "cross-trade" between the legitimate, internal, accounts and his fictitious "88888" account. He would also record trades that were never executed on the Exchange.
In January 1995, a huge earthquake hit Japan, sending its financial markets reeling. The Nikkei crashed, which adversely affected Leeson's position (remember, he had been selling options). It was only then that he tried to hedge his positions, but it was too late. By late February, he faxed a letter of resignation, and when his position was discovered, he had lost $1.4 billion USD. Barings, the bank which financed the Louisiana Purchase between the US and France, became insolvent and was sold to a competing bank for $1.00!
(If you are interested in more details regarding this infamous case, you can read "Rogue Trader" by Nick Leeson himself. There is also a movie of the same name starring Ewan McGregor which should be available on Netflix or DVD.)
The following two case studies are brief descriptions of similar, catastrophic losses by traders with little, or no, oversight.
Optional video: Nick Leeson, The Rogue Trader
You can watch the complete interview here [1].
Robert Citron was the Treasurer for Orange County, California, in the early 90s. He was solely responsible for investing several of the county’s funds, which totaled about $7.5 billion USD. Despite having no background in trading financial instruments, he decided to invest in risky interest rate swaps that were tied to the US Treasury Department’s rates.
Citron was a County Tax Collector with no college degree who was later elected to the position of Orange County Treasurer. In this capacity, he was able to push for California legislative approval for county treasurers to increase their use of financial instruments for investment and fund management.
He was attempting to arbitrage the difference between short-term and long-term interest rates. His position was sound, and he could make money so long as short-term rates remained low. During his tenure, the average return on county investments was a healthy 9.4%, but interest rates had been low for that long. The position he took would lose money if interest rates rose. And, he inflated the county’s volumetric position by entering into other derivatives that would also be negatively impacted by higher interest rates.
Beginning in February 1994 the Federal Reserve Board made the first of six consecutive interest rate hikes. Between February and May of that year, the County had to produce $515 million in cash (margin) to cover its position. Further margin calls would occur throughout the year, leaving the County's cash reserves at only $350 million by November 1994.
When word got out about the County's troubles raising cash, investors sought to retrieve their money, and by December 6, 1994, the County declared bankruptcy and lost $1.64 billion.
MG was a huge, German industrial conglomerate that decided to open an energy trading office in the US in the early 90s.
The original plan was threefold:
When the strategy was first implemented in 1992, current physical prices were lower than the futures prices. So, the sales contracts were set at those higher future prices. And it meant that purchasing the "near" month futures contracts would be profitable. So, MG developed a strategy whereby they would cover the long-term, fixed-price sales by buying contracts in these few, near months. As each month "rolled off," they would merely buy contracts in the next month. It was their intent to continue this process until the physical product sales contracts expired in 10 years. This strategy worked as long as the futures market was "backwardated," whereby each successive month is lower than the prior one (Lesson 3).
One of the major flaws in this approach, however, was the volume of contracts being traded since they were "loading up" on closer month contracts. Add to that, the fact that they would not get paid for the product sales for years out, and you begin to have a cash flow problem where margin calls are concerned. Their position in the fall of 1993 was estimated to be between 160 and 180 million barrels, stretched out over the following 10 years.
In 1993, prices fell as the market received a "bearish" signal from OPEC on production quotas. This lowered futures prices and reversed the market from "backwardated" to "contango," whereby each successive month's price is higher than the prior one (Lesson 3). Faced with this position, MG management was changed, and the new team was directed to close all positions. This resulted in losses on the futures purchases totaling almost $1.5 billion USD. They had to seek bailout funds from one of their banks, and in return, had to sell off several divisions. Today, the German industrial giant no longer exists, having been bought out by a competitor.
Please watch the following video (6:20).
There were some common themes that ran through each of these cases:
These events, along with others, prompted the financial industry to institute ways to monitor, track and stay on top of, financial derivative trading. These same methods would later have to be adopted by publicly traded energy companies in the US.
Please watch the following 6:33 minute video about Risk Control.
Please watch the following 14 minute video about Risk Control.
You have reached the end of this lesson. Double-check the list of requirements on the first page of this lesson to make sure you have completed all of the activities.