Behavioural Finance

LTCM & Barring Bank

Submitted By
Group No. 10

Chaitali Kambli 20152066

Debashish Mishra 20152068
Aarti Vaishnaw 20152070
Collapse of Long-Term Capital Management
CASE

John Meriwether, who founded Long-Term Capital Partners in 1993, had been head of
fixed income trading at Salomon Brothers. Even when forced to leave Salomon in 1991,
in the wake of the firm's treasury auction rigging scandal (another marker buoy),
Meriwether continued to command huge loyalty from a team of highly cerebral relative-
value fixed income traders, and considerable respect from the street. Teamed up with a
handful of these traders, two Nobel laureates, Robert Merton and Myron Scholes, and
former regulator David Mullins, Meriwether and LTCM had more credibility than the average
broker/dealer on Wall Street. It was a game, in that LTCM was unregulated, free to
operate in any market, without capital charges and only light reporting requirements to
the US Securities & Exchange Commission (SEC). It traded on its good name with many
respectable counterparties as if it was a member of the same club. That meant an
ability to put on interest rate swaps at the market rate for no initial margin - an
essential part of its strategy. It meant being able to borrow 100% of the value of any top-
grade collateral, and with that cash to buy more securities and post them as collateral
for further borrowing: in theory it could leverage itself to infinity. In LTCM's first two full
years of operation it produced 43% and 41% return on equity and had amassed an
investment capital of $7 billion. Meriwether was renowned as a relative-value trader.
Relative value means (in theory) taking little outright market risk, since a long position in
one instrument is offset by a short position in a similar instrument or its derivative. It
means betting on small price differences which are likely to converge over time as the
arbitrage is spotted by the rest of the market and eroded. Trades typical of early LTCM
were, for example, to buy Italian government bonds and sell German Bund futures; to
buy theoretically under-priced off-the-run US treasury bonds (because they are less
liquid) and go short on-the-run (more liquid) treasuries. It played the same arbitrage in the
interest-rate swap market, betting that the spread between swap rates and the most liquid
treasury bonds would narrow. It played long-dated callable Bunds against Dm swaptions. It
was one of the biggest players on the world's futures exchanges, not only in debt but also
equity products. To make 40% return on capital, however, leverage had to be applied. In
theory, market risk isn't increased by stepping up volume, provided you stick to liquid
instruments and don't get so big that you yourself become the market. Some of the big
macro hedge funds had encountered this problem and reduced their size by giving
money back to their investors. When, in the last quarter of 1997 LTCM returned $2.7 billion
to investors, it was assumed to be for the same reason: a prudent reduction in its
positions relative to the market. But it seems the positions weren't reduced relative to
the capital reduction, so the leverage increased. Moreover, other risks had been added to
the equation. LTCM played the credit spread between mortgage-backed securities
(including Danish mortgages) or double-A corporate bonds and the government bond
markets. Then it ventured into equity trades. It sold equity index options, taking big
premium in 1997. It took speculative positions in takeover stocks, according to press
reports. One such was Tellabs whose share price fell over 40% when it failed to take
over Ciena, says one account. A filing with the SEC for June 30 1998 showed that LTCM
had equity stakes in 77 companies, worth $541 million. It also got into emerging markets,
including Russia. One report said Russia was "8% of its book" which would come to $10
billion! Some of LTCM's biggest competitors, the investment banks, had been clamouring
to buy into the fund. Meriwether applied a formula which brought in new investment, as
well as providing him and his partners with a virtual put option on the performance of the
fund. During 1997, under this formula [see separate section below, titled UBS Fiasco],
UBS put in $800 million in the form of a loan and $266 million in straight equity. Credit
Suisse Financial Products put in a $100 million loan and $33 million in equity. Other
loans may have been secured in this way, but they haven't been made public. Investors
in LTCM were pledged to keep in their money for at least two years. LTCM entered
1998 with its capital reduced to $4.8 billion. A New York Sunday Times article says the big
trouble for LTCM started on July 17 when Salomon Smith Barney announced it was
liquidating its dollar interest arbitrage positions: "For the rest of the that month, the fund
dropped about 10% because Salomon Brothers was selling all the things that Long-Term
owned." [The article was written by Michael Lewis, former Salomon bond trader and
author of Liar's Poker. Lewis visited his former colleagues at LTCM after the crisis and
describes some of the trades on the firm's books] On August 17,1998 Russia declared a
moratorium on its rouble debt and domestic dollar debt. Hot money, already jittery
because of the Asian crisis, fled into high quality instruments. Top preference was for the
most liquid US and G-10 government bonds. Spreads widened even between on- and off-
the-run US treasuries.
On September 2, 1998 Meriwether sent a letter to his investors saying that the fund had
lost $2.5 billion or 52% of its value that year, $2.1 billion in August alone. Its capital base
had shrunk to $2.3 billion. Meriwether was looking for fresh investment of around $1.5
billion to carry the fund through. He approached those known to have such investible
capital, including George Soros, Julian Robertson and Warren Buffett, chairman of
Berkshire Hathaway and previously an investor in Salomon Brothers [LTCM incidentally
had a $14 million equity stake in Berkshire Hathaway], and Jon Corzine, then co-
chairman and co-chief executive officer at Goldman Sachs, an erstwhile classmate at
the University of Chicago. Goldman and JP Morgan were also asked to scour the market
for capital. But offers of new capital weren't forthcoming. Perhaps these big players were
waiting for the price of an equity stake in LTCM to fall further. Or they were making
money just trading against LTCM's positions. Under these circumstances, if true, it was
difficult and dangerous for LTCM to show potential buyers more details of its portfolio. Two
Merrill executives visited LTCM headquarters on September 9, 1998for a "due diligence
meeting", according to a later Financial Times report (on October 30, 1998). They were
provided with "general information about the fund's portfolio, its strategies, the losses to
date and the intention to reduce risk". But LTCM didn't disclose its trading positions,
books or documents of any kind, Merrill is quoted as saying. The US Federal Reserve
system, particularly the New York Fed which is closest to Wall Street, began to hear
concerns about LTCM from its constituent banks. In the third week of September, Bear
Stearns, which was LTCM's clearing agent, said it wanted another $500 million in
collateral to continue clearing LTCM's trades. On Friday September 18, 1998, New York
Fed chairman Bill McDonough made "a series of calls to senior Wall Street officials to
discuss overall market conditions", he told the House Committee on Banking and
Financial Services on October 1. "Everyone I spoke to that day volunteered concern
about the serious effect the deteriorating situation of Long-Term could have on world
markets." Peter Fisher, executive vice president at the NY Fed, decided to take a look
at the LTCM portfolio. On Sunday September 20, 1998, he and two Fed colleagues,
assistant treasury secretary Gary Gensler, and bankers from Goldman and JP Morgan,
visited LTCM's offices at Greenwich, Connecticut. They were all surprised by what they
saw. It was clear that, although LTCM's major counterparties had closely monitored their
bilateral positions, they had no inkling of LTCM's total off balance sheet leverage. LTCM
had done swap upon swap with 36 different counterparties. In many cases it had put on
a new swap to reverse a position rather than unwind the first swap, which would have
required a mark-to-market cash payment in one direction or the other. LTCM's on balance
sheet assets totalled around $125 billion, on a capital base of $4 billion, a leverage of
about 30 times. But that leverage was increased tenfold by LTCM's off balance sheet
business whose notional principal ran to around $1 trillion. The off balance sheet
contracts were mostly nettable under bilateral Isda (International Swaps & Derivatives
Association) master agreements. Most of them were also collateralized. Unfortunately the
value of the collateral had taken a dive since August 17. Surely LTCM, with two of the
original masters of derivatives and option valuation among its partners, would have put
its portfolio through stress tests to match recent market turmoil. But, like many other
value-at-risk (Var) modellers on the street, their worst-case scenarios had been outplayed
by the horribly correlated behaviour of the market since August 17. Such a flight to
quality hadn't been predicted, probably because it was so clearly irrational. According to
LTCM managers their stress tests had involved looking at the 12 biggest deals with each
of their top 20 counterparties. That produced a worst-case loss of around $3 billion. But
on that Sunday evening it seemed the mark-to-market loss, just on those 240-or-so
deals, might reach $5 billion. And that was ignoring all the other trades, some of them in
highly speculative and illiquid instruments. The next day, Monday September 21, 1998,
bankers from Merrill, Goldman and JP Morgan continued to review the problem. It was
still hoped that a single buyer for the portfolio could be found - the cleanest solution.
According to Lewis's article LTCM's portfolio had its second biggest loss that day, of
$500 million. Half of that, says Lewis, was lost on a short position in five-year equity
options. Lewis records brokers' opinion that AIG had intervened in thin markets to drive
up the option price to profit from LTCM's weakness. At that time, as was learned later,
AIG was part of a consortium negotiating to buy LTCM's portfolio. By this time LTCM's
capital base had dwindled to a mere $600 million. That evening, UBS, with its
particular exposure on a $800 million credit, with $266 million invested as a hedge, sent a
team to Greenwich to study the portfolio. The Feds Peter Fischer invited those three banks
and UBS to breakfast at the Fed headquarters in Liberty Street the following day. The
bankers decided to form working groups to study possible market solutions to the
problem, given the absence of a single buyer. Proposals included buying LTCM's fixed
income positions, and "lifting" the equity positions (which were a mixture of index
spread trades and total return swaps, and the takeover bets). During the day a third
option emerged as the most promising: seeking recapitalization of the portfolio by a
consortium of creditors. But any action had to be taken swiftly. The danger was a single
default by LTCM would trigger cross-default clauses in its Isda master agreements
precipitating a mass close-out in the over-the-counter derivatives markets. Banks
terminating their positions with LTCM would have to rebalance any hedge they might
have on the other side. The market would quickly get wind of their need to rebalance
and move against them. Mark-to-market values would descend in a vicious spiral. In the
case of the French equity index, the CAC 40, LTCM had apparently sold short up to
30% of the volatility of the entire underlying market. The Banque de France was worried
that a rapid close-out would severely hit French equities. There was a wider concern that
an unknown number of market players had convergence positions similar or identical to
those of LTCM. In such a one-way market there could be a panic rush for the door. A
meltdown of developed markets on top of the panic in emerging markets seemed a real
possibility. LTCM's clearing agent Bear Stearns was threatening to foreclose the next day
if it didn't see $500 million more collateral. Until now, LTCM had resisted the temptation
to draw on a $900 million standby facility that had been syndicated by Chase Manhattan
Bank, because it knew that the action would panic its counterparties. But the situation
was now desperate. LTCM asked Chase for $500 million. It received only $470 million
since two syndicate members refused to chip in. To take the consortium plan further,
the biggest banks, either big creditors to LTCM, or big players in the over-the-counter
markets, were asked to a meeting at the Fed that evening. The plan was to get 16 of
them to chip in $250 million each to recapitalize LTCM at $4 billion. The four core banks
met at 7pm and reviewed a term sheet which had been drafted by Merrill Lynch. Then
at 8.30 bankers from nine more institutions showed. They represented: Bankers Trust,
Barclays, Bear Stearns, Chase, Credit Suisse First Boston, Deutsche Bank, Lehman
Brothers, Morgan Stanley, Credit Agricole, Banque Paribas, Salomon Smith Barney,
Societe Generale. David Pflug, head of global credit risk at Chase warned that nothing
would be gained a) by raking over the mistakes that had got them in this room, and b)
by arguing about who had the biggest exposure: they were all in this equally and together.
The delicate question was how to preserve value in the LTCM portfolio, given that banks
around the room would be equity investors, and yet, at the same time, they would be
seeking to liquidate their own positions with LTCM to maximum advantage. It was clear
that John Meriwether and his partners would have to be involved in keeping such a
complex portfolio a going concern. But what incentive would they have if they no longer
had an interest in the profits? Chase insisted that any bailout would first have to return
the $470 million drawn down on the syndicated standby facility. But nothing could be
finalized that night since few of the representatives present could pledge $250 million or
more of their firm's money. The meeting resumed at 9.30 the next morning. Goldman
Sachs had a surprise: its client, Warren Buffett, was offering to buy the LTCM portfolio
for $250 million, and recapitalize it with $3 billion from his Berkshire Hathaway group,
$700 million from AIG and $300 million from Goldman. There would be no
management role for Meriwether and his team. None of LTCM's existing liabilities would
be picked up, yet all current financing had to stay in place. Meriwether had until 12.30 to
decide. By 1pm it was clear that Meriwether had rejected the offer, either because he
didn't like it, or, according to his lawyers, because he couldn't do so without consulting his
investors, which would have taken him over the deadline. The bankers were somewhat
flabbergasted by Goldman's dual role. Despite frequent requests for information about
other possible bidders, Goldman had dropped no hint at previous meetings that there was
something in the pipeline. Now the banks were back to the consortium solution. Since
there were only 13 banks, not 16, they'd have to put in more than $250 million each.
Bear Stearns offered nothing, feeling that it had enough risk as LTCM's clearing agent.
[Their special relationship may have been the source of some acrimony: LTCM had an
$18 million equity stake in Bear Stearns, matched by investments in LTCM of $10
million each by Bear Stearns principals James Cayne and Warren Spector]. Lehman
Brothers also declined to participate . In the end 11 banks put in $300 million each,
Societe Generale $125 million, and Credit Agricole and Paribas $100 million each,
reaching a total fresh equity of $3.625 billion. Meriwether and his team would retain a
stake of 10% in the company. They would run the portfolio under the scrutiny of an
oversight committee representing the new shareholding consortium. The message to the
market was that there would be no fire-sale of assets. The LTCM portfolio would be
managed as a going concern. In the first two weeks after the bail-out, LTCM continued to
lose value, particularly on its dollar/yen trades, according to press reports which put the
loss at $200 million to $300 million. There were more attempts to sell the portfolio to a
single buyer. According to press reports the new LTCM shareholders had further talks with
Buffett, and with Saudi prince Alwaleed bin talal bin Abdelaziz. But there was no sale. By
mid-December, 1998 the fund was reporting a profit of $400 million, net of fees to LTCM
partners and staff. In early February, 1999 there were press reports of divisions between
banks in the bailout consortium, some wishing to get their money out by the end of the
year, others happy to "stay for the ride" of at least three years. There was also a dispute
about how much Chase was charging for a funding facility to LTCM. Within six months
there were reports that Meriwether and some of his team wanted to buy out the banks,
with a little help from their friend Jon Corzine, who was due to leave Goldman Sachs after
its flotation in May, 1999. By June 30, 1999 the fund was up 14.1%, net of fees, from last
September. Meriwether's plan approved by the consortium, was apparently to redeem the
fund, now valued at around $4.7 billion, and to start another fund concentrating on
buyouts and mortgages. On July 6, 1999, LTCM repaid $300 million to its original
investors who had a residual stake in the fund of around 9%. It also paid out $1 billion to
the 14 consortium members. It seemed Meriwether was bouncing back.

Causes of Collapse

The Proximate Cause: Russian Sovereign Default

The proximate cause for LTCM's debacle was Russia's default on its government
obligations (GKOs). LTCM believed it had somewhat hedged its GKO position by selling
rubles. In theory, if Russia defaulted on its bonds, then the value of its currency would
collapse and a profit could be made in the foreign exchange market that would offset the
loss on the bonds. Unfortunately, the banks guaranteeing the ruble hedge shut down
when the Russian ruble collapsed, and the Russian government prevented further trading
in its currency. (The Financial Post, 9/26/98). While this caused significant losses for
LTCM, these losses were not even close to being large enough to bring the hedge fund
down. Rather, the ultimate cause of its demise was the ensuing flight to liquidity described
in the following section.

The Ultimate Cause: Flight to Liquidity

The ultimate cause of the LTCM debacle was the "flight to liquidity" across the global fixed
income markets. As Russia's troubles became deeper and deeper, fixed-income portfolio
managers began to shift their assets to more liquid assets. In particular, many investors
shifted their investments into the U.S. Treasury market. In fact, so great was the panic that
investors moved money not just into Treasurys, but into the most liquid part of the U.S.
Treasury market -- the most recently issued, or "on-the-run" Treasuries. While the U.S.
Treasury market is relatively liquid in normal market conditions, this global flight to liquidity
hit the on-the-run Treasuries like a freight train. The spread between the yields on on-the-
run Treasuries and off-the-run Treasuries widened dramatically: even though the off-the-run
bonds were theoretically cheap relative to the on-the-run bonds, they got much cheaper still
(on a relative basis). What LTCM had failed to account for is that a substantial portion of
its balance sheet was exposed to a general change in the "price" of liquidity. If liquidity
became more valuable (as it did following the crisis) its short positions would increase in
price relative to its long positions. This was essentially a massive, unhedged exposure to a
single risk factor. As an aside, this situation was made worse by the fact that the size of
the new issuance of U.S. Treasury bonds has declined over the past several years. This has
effectively reduced the liquidity of the Treasury market, making it more likely that a flight to
liquidity could dislocate this market.
Systemic Risk: The Domino Effect

The preceding analysis explains why LTCM almost failed. However, it does not explain why
this near-failure should threaten the stability of the global financial markets. The reason
was that virtually all of the leveraged Treasury bond investors had similar positions:
Salomon Brothers, Merrill Lynch, the III Fund (a fixed-income hedge fund that also failed
as a result of the crisis) and likely others. There were two reasons for the lack of diversity
of opinion in the market. The first is that virtually all of the sophisticated models being run
by the leveraged players said the same thing: that offthe-run Treasuries were significantly
cheap compared with the on-the-run Treasuries. The second is that many of the
investment banks obtained order flow information through their dealings with LTCM. They
therefore would have known many of the actual positions and would have taken up similar
positions alongside their client. Indeed, one industry participant suggested that the
Russian crisis was the crowning blow on a domino effect that had started months before.
In early 1998, Sandy Weill, as co-head of Citigroup, decided to shut down the famous
Salomon Brothers Treasury bond arbitrage desk. Salomon, one of the largest players in the
on-the-run/off-the-run trade, had to begin liquidating its positions. As it did so, these trades
became cheaper and cheaper, putting pressure on all of the other leveraged players.

The total losses were found to be $4.6 billion. The losses in the major investment
categories were (ordered by magnitude):

$1.6 billion in swaps

$1.3 billion in equity volatility
$430 million in Russia and other emerging markets
$371 million in directional trades in developed countries
$286 million in equity pairs (such as VW, Shell)
$215 million in yield curve arbitrage
$203 million in S&P 500 stocks
$100 million in junk bond arbitrage
no substantial losses in merger arbitrage
The Subsequent Bailout

Wall Street feared that the downfall of LTCM could have spiralling effects in the
global financial markets causing catastrophic losses throughout the financial system.
Goldman Sachs, AIG and Berkshire Hathaway on September 23, 1998 offered to
buy out the funds partners for $250 million and decided to inject $3.75 billion and to
operate LTCM within Goldmans own trading division. The final bailout was $3.65
billion.

LTCM continued normal operations after that.

Lessons to be learned:

Market values matter

LTCM was perhaps the biggest disaster of its kind, but it was not the first. It had been
preceded by a number of other cases of highly-leveraged quantitative firms that went under
in similar circumstances.
One of the earliest was Franklin Savings and Loan, a hedge fund dressed down as a
savings & loan. Franklin's management had figured out that many of the riskier pieces of
mortgage derivatives were undervalued because a) the market could not understand the
risk on the risky pieces; and b) the market overvalued those pieces with well-behaved
accounting results. Franklin decided it was willing to suffer volatile accounting results in
exchange for good economics.
More recently, the Granite funds, which specialised in mortgage-backed securities trading,
suffered as the result of similar trading strategies. The funds took advantage of the fact that
"toxic waste" (risky tranches) from the mortgage derivatives market were good economic
value. However, when the Fed raised interest rates in February 1994, Wall Street firms
rushed to liquidate mortgage-backed securities, often at huge discounts.
Both of these firms claimed to have been hedged, but both went under when they were
"margincalled". In Franklin's case, the caller was the Office of Thrift Supervision; in the
Granite Fund's, the margin lenders. What is the common theme among Franklin, the
Granite Funds and LTCM? All three depended on exploiting deviations in market value from
fair value. And all three depended on "patient capital" -- shareholders and lenders who
believed that what mattered was fair value and not market value. That is, these fund
managers convinced their stakeholders that because the fair values were hedged, it didn't
matter what happened to market values in the short run they would converge to fair
value over time. That was the reason for the "Long Term" part of LTCM's name.
The problem with this logic is that capital is only as patient as its least patient provider. The
fact is that lenders generally lose their patience precisely when the funds need them to
keep it in times of market crisis. As all three cases demonstrate, the lenders are the first
to get nervous when an external shock hits. At that point, they begin to ask the fund
manager for market valuations, not models-based fair valuations. This starts the fund along
the downward spiral: illiquid securities are marked-to-market; margin calls are made; the
illiquid securities must be sold; more margin calls are made, and so on. In general,
shareholders may provide patient capital; but debt-holders do not.
The lesson learned from these case studies spoils some of the supposed "free lunch"
features of taking liquidity risk. These plays can indeed generate excellent risk-adjusted
returns, but only if held for a long time. Unfortunately the only real source of capital that is
patient enough to take fluctuations in market values, especially through crises, is equity
capital.

Liquidity risk is itself a factor

As pointed out in the analysis section of this article, LTCM fell victim to a flight to liquidity.
This phenomenon is common enough in capital markets crises that it should be built into
risk models, either by introducing a new risk factor liquidity or by including a flight to
liquidity in the stress testing (see the following section for more detail on this). This could
be accomplished crudely by classifying securities as either liquid or illiquid. Liquid
securities are assigned a positive exposure to the liquidity factor; illiquid securities are
assigned a negative exposure to the liquidity factor. The size of the factor movement
(measured in terms of the movement of the spread between liquid and illiquid securities)
can be estimated either statistically or heuristically (perhaps using the LTCM crisis as a
"worst case" scenario). Using this approach, LTCM might have classified most of its long
positions as illiquid and most of its short positions as liquid, thus having a notional exposure
to the liquidity factor equal to twice its total balance sheet. A more refined model would
account for a spectrum of possible liquidity across securities; at a minimum, however, the
general concept of exposure to a liquidity risk factor should be incorporated in to any
leveraged portfolio

Models must be stress-tested and combined with judgement

Another key lesson to be learnt from the LTCM debacle is that even (or especially) the
most sophisticated financial models are subject to model risk and parameter risk, and
should therefore be stress-tested and tempered with judgement. While we are clearly
privileged in exercising 20/20 hindsight, we can nonetheless think through the way in which
judgement and stresstesting could have been used to mitigate, if not avoid, this disaster.
According to the complex mathematical models used by LTCM, the positions were low
risk. Judgement tells us that the key assumption that the models depended on was the high
correlation between the long and short positions. Certainly, recent history suggested that
correlations between corporate bonds of different credit quality would move together (a
correlation of between 90-95% over a 2-year horizon). During LTCM's crisis, however, this
correlation dropped to 80%. Stress-testing against this lower correlation might have led
LTCM to assume less leverage in taking this bet. However, if LTCM had thought to stress
test this correlation, given that it was such an important assumption, it would not even
have had to make up a stress scenario. This correlation had dropped to 75% as recently
as 1992 (Jorion, 1999). Simply including this stress scenario in the risk management of the
fund might have led LTCM to assume less leverage in taking this bet.
Financial institutions must aggregate exposures to common risk factors
One of the other lessons to be learned by other financial institutions is that it is important to
aggregate risk exposures across businesses. Many of the large dealer banks exposed to
a Russian crisis across many different businesses only became aware of the commonality
of these exposures after the LTCM crisis. For example, these banks owned Russian GKOs
on their arbitrage desks, made commercial loans to Russian corporates in their lending
businesses, and had indirect exposure to a Russian crisis through their prime brokerage
lending to LTCM. A systematic risk management process should have discovered these
common linkages ex ante and reported or reduced the risk concentration.

The LTCM is full of lessons about:

1. Model risk
2. Unexpected correlation or the breakdown of historical correlations
3. The need for stress-testing
4. The value of disclosure and transparency
5. The danger of over-generous extension of trading credit
6. The woes of investing in star quality
7. And investing too little in game theory.
Barings Bank
Barings Bank was founded in London in 1763 which rose to become the Britains oldest
Merchant Bank as well as becoming the leading Merchant Bank. As such, it provided
traditional banking services to the public while performing investment activities in stocks,
bonds, commodities and real estate. The bank focused in investment sector activities which
could lead to success in trading on the future. By 1989, Barings had established trading
operations at most of the worlds exchanges operating began in British Commonwealth
countries and former British colonies. By being creative and flexible in crafting the financial
solutions for organizations, Barings Bank enjoying grew up steadily over time across the
globe. In February 1995, the bank was discovered in involving a huge fraud scheme,
perpetrated by one of its traders in Singapore-Nick Leeson. He had wiped out the banks
capital and destroyed the 220 year old institution.

Introduction of Nick Leeson:

Previously, Nick Leeson had graduated from college and spent two years at Morgan Stanley
as a settlement clerk and in duties on clearing the huge futures and options deals. In 1989,
this young commodities trader joined Baring Securities Ltd (BSL) and working primarily in
the settlements department. In the mean time, he had applied to become a dealer with the
Securities and Futures Authority (SFA) in London early 1992. After the first quarter of 1992,
Leeson was posted to Baring Futures Singapore Ltd (BFS) to perform the settlement
operations as well as the floor manager at the Singapore International Monetary Exchange
(SIMEX). This is the beginning opportunity for Nick Leeson to bring down the Barings Bank
due to the inconsistency of the risk management fundamental. Leeson was selected to
open, run and manage the new operation in Singapore, managing all aspects of trading on
SIMEX and he had been with the Barings Bank approximately three years and possessed a
total of five years experience in banking.
What was the strategy being implemented by Nick Leeson?

Around 1990s, derivative market is rapid growth financial instrument around the American
and European markets even the Asia-Pacific region. The Barings Bank board was decided to
actively participate in the Asia-Pacifics derivative market in order to become one of the first
active bankers in the derivative market. That is the reason for Barings Bank employed and
sent Nick Leeson, a young trader as general manager of the Barings Bank Futures
subsidiary in Singapore to manage the derivative operation.
Nick Leeson was given a lot of freedom by Barings Bank in the derivative trading since he
was the one who deem to know very well of the derivative market operation. He was
appointed to in charge of both client and proprietary account on behalf of Barings Bank
trading in Asia-Pacific region. He was traded in several main financial futures and option
exchanges as following:
Nikkei 225 contract traded on SIMEX in Singapore and OSE (Osaka Stock
Exchange) in Japan
10 year JGB (Japanese government bonds) contract dealt in SIMEX and OSE.
3-month Euroyen contract dealt in SIMEX and TIFFE (Tokyo Financial Futures
Exchange) in the Japan.
In the early state, Barings Banks management was planned to operate an inter-
exchange arbitrate strategy. This strategy required Nick Leeson to buy and sell
Nikkei 225 futures contracts simultaneously on both SIMEX and OSE market in
order to gain the arbitrate profit from the different in price of the Nikkei 225 futures
contracts.( Buying at lower price and selling at higher price). This strategy would
consider as a risk-free investment and provide good opportunity for profit in the high
volatile market. However, due to the contracts price is slightly different, the profit
earn is small. Because of this, Nick Leeson was decided to change the strategy.
The strategy implemented by Nick Leeson named as straddle with the objective of making
a profit by short put and call options on the same underlying assets Nikkei 225 Index.

How Nick Leeson Became Barings Banks Superstar

Nick Leeson grew up in Londons Watford suburb and worked for Morgan Stanley after
graduating from university. Shortly after, Leeson joined Barings and was transferred to
Jakarta, Indonesia to sort through a back-office mess involving 100 million of share
certificates. Nick Leeson enhanced his reputation within Barings when he successfully
rectified the situation in 10 months (Risk Glossary).
In 1992, after his initial success, Nick Leeson was transferred to Barings Securities in
Singapore and was promoted to general manager, with the authority to hire traders and back
office staff. Leesons experience with trading was limited, but he took an exam that qualified
him to trade on the Singapore Mercantile Exchange (SIMEX) alongside his traders.
According to Risk Glossary:

Leeson and his traders had authority to perform two types of trading:

1. Transacting futures and options orders for clients or for other firms within the Barings
organization, and

2. Arbitraging price differences between Nikkei futures traded on the SIMEX and Japans
Osaka exchange.

Arbitrage is an inherently low risk strategy and was intended for Leeson and his team to
garner a series of small profits, rather than spectacular gains.

As a general manager, Nick Leeson oversaw both trading and back office functions,
eliminating the necessary checks and balances usually found within trading organizations. In
addition, Barings senior management came from a merchant banking background, causing
them to underestimate the risks involved with trading, while not providing any individual who
was directly responsible for monitoring Leesons trading activities (eRisk). Aided by his lack
of supervision, the 28-year-old Nick Leeson promptly started unauthorized speculation in
Nikkei 225 stock index futures and Japanese government bonds (Risk Glossary). These
trades were outright trades or directional bets on the market. This highly leveraged strategy
can provide fantastic gains or utterly devastating losses a stark contrast to the relatively
conservative arbitrage trading that Barings had intended for Leeson to pursue.

Nick Leeson Caused the Failure of Barings Bank

Nick Leeson opened a secret trading account that was numbered 88888 to facilitate his
surreptitious trading. Risk Glossary says of Leeson:

He lost money from the beginning. Increasing his bets only made him lose more money. By
the end of 1992, the 88888 account was under water by about GBP 2MM. A year later, this
had mushroomed to GBP 23MM. By the end of 1994, Leesons 88888 account had lost a
total of GBP 208MM. Barings management remained blithely unaware.

As a trader, Leeson had extremely bad luck. By mid February 1995, he had accumulated an
enormous positionhalf the open interest in the Nikkei future and 85% of the open interest
in the JGB [Japanese Government Bond] future. The market was aware of this and probably
traded against him. Prior to 1995, however, he just made consistently bad bets. The fact that
he was so unlucky shouldnt be too much of a surprise. If he hadnt been so misfortunate, we
probably wouldnt have ever heard of him.

Betting on the recovery of the Japanese stock market, Nick Leeson suffered monumental
losses as the market continued its descent. In January 1995, a powerful earthquake shook
Japan, dropping the Nikkei 1000 points while pulling Barings even further into the red. As an
inexperienced trader, Leeson frantically purchased even more Nikkei futures contracts in
hopes of winning back the money that he had already lost. Most successful traders,
however, are quick to admit their mistakes and cut their losing trades.

Surprisingly, Nick Leeson effectively managed to avert suspicion from senior management
through his sly use of account number 88888 for hiding losses, while he posted profits in
other trading accounts. In 1994, Leeson fabricated 28.55 million in false profits, securing
his reputation as a star trader and gaining bonuses for Barings employees (Risk Glossary).
Despite the staggering secret losses, Leeson lived the life of a high roller, complete with a
$9,000 per month apartment and earning a bonus of 130,000 on his salary of 50,000,
according to How Leeson Broke the Bank.

Leeson lived the life of a high roller, complete with a $9,000 per month apartment and
earning a bonus of 130,000 on his salary of 50,000, according to How Leeson Broke the
Bank.

The horrific losses accrued by Nick Leeson were due to his financial gambling as he placed
his trades based upon his emotions rather than through taking calculated risks. After the
collapse of Barings, a worldwide outrage ensued, decrying the use of derivatives. The truth,
however, is that derivatives are only as dangerous as theNick Leeson was placed on trial in
Singapore and was convicted of fraud. He was sentenced to six and a half years in a
Singaporean prison, where he contracted cancer (Risk Glossary). He survived his cancer,
and, while imprisoned, wrote an autobiography called Rogue Trader, detailing his role in
the Barings scandal. Rogue Trader was eventually made into a movie of the same name.
Nick Leeson was released from prison in July 1999 for good behavior.

The Collapse of Barings Bank

In 1984, the merchant bank Barings & Co acquired a team from a UK broker, Henderson
Crosthwaite, and began building a subsidiary, Barings Securities Limited (BSL), specializing
in trading Far Eastern securities. Barings recruited Nick Leeson in July, 1989, to work in
futures and options settlement in its London office. In March, 1992, Nick Leeson was
transferred to Singapore to run the back office of Barings Future Singapore (BFS), a Barings
subsidiary involved in futures dealing on the Singapore Monetary Exchange, SIMEX. He was
promoted rapidly and by late 1992 he was BFSs general manager and head trader. Much of
BFSs business consisted of own-account trading aimed at exploiting small pricing
differences between similar contracts on the Singapore and Japanese exchanges. It also
acted as broker for clients wishing to trade on SIMEX. From late 1992 until early 1995,
Leeson reported increasingly large profits on apparently risk free arbitrage trading in which
positions on SIMEX were supposedly hedged by equal, offsetting positions on Japanese
exchanges. In fact, Leeson was conducting an elaborate deception. From the first, he made
losses. To conceal the losses, Leeson employed a hidden SIMEX account numbered 88888,
persuading a back office programmer to alter Barings accounting systems so that the
information about 88888 would not be reported back to London. The fact that Leeson was in
charge of both dealing and back office operations in BFS was crucial in facilitating the
deception. In August, 1994, an internal audit of BSL concluded that the lack of segregation
between front and back offices should be reflected but Barings management did not
implement the recommendation. In January, 1995, SIMEX became concerned that Barings
might be financing its clients trading, in particular an account 88888, against the rules of the
exchange. It wrote to BSL to query this. Also in January, the BFS auditors, Coopers &
Lybrand Singapore, became concerned about a receivable of 50 million, apparently due
from a New York-based trader. In fact, Leeson had forged the documentation on this
receivable in his efforts to cover up his activities in raising funds for margin payments on his
increasingly large losses. In early February, Barings dispatched London staff to Singapore to
establish what was happening. In the week beginning February 13 a settlement clerk sent
from London found an apparent gap of $ 200 million in BFSs positions. On the evening of
February 23, Leeson and his wife fled to Kuala Lumpur, from where he faxed his resignation.
Strenuous efforts by the Bank of England to organize a rescue of Barings on the following
three days failed largely because it was impossible to gauge Barings exposure accurately.
On the night of February 26, Barings was therefore declared insolvent as of February 27,
1995, to the tune of 827 million. The cumulative loss after liquidation was 927 million. A
week later, Barings was taken over by International Nederlands Group NV (ING), a large
Dutch banking and insurance group. The SFA took disciplinary action against individual
directors of Barings resulting in several being banned as directors or managers.

Derivative despair

The Barings disaster raises fresh questions about the financial markets' policemen. The
British government has already ordered an inquiry. It will want to establish if the exchanges
or their regulators could have done more to stop the bank from its own folly. It will also look
again at the vexed questions of whether the globalization of financial markets and the spread
of derivatives trading require tough new regulations. The exchanges probably could have
done better. Neither the Osaka nor the Singapore markets emerge from this affair covered in
glory. They failed to ferret out why Baring Futures was racking up unusually large positions.
They asked for information; but the firm seems to have responded with a few fictitious client
names. Nor are the exchanges good at sharing information. This is because the OSE is
cross that SIMEX stole its business after the Japanese authorities forced it to raise its
margin rates to the highest in the world. Yet neither exchange can hope to prevent firms
going bust - and thus putting their members' capital at risk - if they do not pool information.
International regulators also need to work together more closely. British regulators have
received only the scantiest of information from the Monetary Authority of Singapore, the
country's bank regulator, even after the Barings collapse. Yet domestic lead regulators -
whose task it is to oversee the entire position of their charges - cannot do their job unless
they keep in touch with banks' activities in other jurisdictions. In this respect, regulators
seem to have gone global less rapidly than their charges. There are clearly risks for
anyone who deals in derivatives; the ease with which they can be used to assume risk
creates hazard. Barings now knows that better than most. Yet the firm also seems to have
learnt little in the 100-odd years since it last went bust. Reams of reports have been written
advising companies how they should manage derivatives risks. The Group of Thirty, a think-
tank, came out with a list of specific recommendations in 1993. By one estimate, Barings
ignored half of them. Its collapse should teach other banks a useful lesson.