By Anuj Jain Suresh Attal Diana Cho Alice Kim 88888: “Five Fat Pigs”

Introduction February 26, 1995 Baring Brothers & Co. collapsed, reducing in value from $500 million to $1.60 The culprit 28 year-old rogue trader, Nicholas Leeson By secretly traded futures contracts on both the Nikkei 225 and on JGB’s (Japanese Government Bonds) The damage $1.4 billion dollars lost

Leeson’s Responsibilities Leeson was authorized to take advantage of arbitrage opportunities available in Osaka and Singapore futures markets on the Nikkei 225 Leeson chose to ignore the strategy which he was supposed to employ The secret account Used to hide the losses

Leeson’s Trading Strategy Went long on Nikkei 225 future contracts Used the option premiums to offset his needs for margin requirements from futures contracts Also went short on Japanese Government Bonds to hedge his exposure partially.

Leeson’s Trading Strategy As losses mounted he took on larger positions – Rogue Trader Other traders choose to take advantage of the big position that Barings had to bet against the firm To stem losses, Leeson would step in to support the market causing him to continue to build up more positions

Tally Sheet By February 23, 1995, Leeson held: 49% total open interest in Mar ’95 Nikkei futures 24% total open interest in Jun ’95 Nikkei futures 88% total open interest in Jun ’95 JGB futures 5% open interest in June ’95 Euroyen futures Adds up to MASSIVE MARGIN CALLS for Baring’s

Leeson’s Plan Leeson placed bets on the direction of price movements on the Tokyo stock exchange Focus: Count on the Nikkei index to rise Felt that the Nikkei had fallen too much and expected it to rebound eventually If it did rebound he would have made a profit on: The increased stock value An increase in interest rates

Selling Options Leeson used straddle approach Option expires “out-of-the-money”  profit However, as price volatility increases, an option seller’s potential losses are unlimited a. Sell Call b. Sell Put c. Sell Straddle strike price Profit

The Worst Possible Scenario… January 17, 1995 Violent earthquake hit Kobe, Japan Nikkei fell 1,500 points Leeson’s options lost ₤68 million PLAN B - Tried to sustain market by: Buying massive amounts of Nikkei stock index futures Selling Japanese government bond futures, betting that interest rates would rise

Concealed Trading Losses

Where Did It Go Wrong? WEAK BALANCE Mostly gambled on direction of markets. A major part of Leeson’s trading strategy involved the purchase of futures on Nikkei- 225 futures contracts His only “hedge” was in holding a short position on JGB’s. He only made a one-sided bet.

The Failure of Internal Controls No clearly laid down reporting lines Several managers responsible for monitoring Leeson’s performance did not do their job No segregation of front and back office activities No comprehensive review of Leeson’s funding requirements

The reason for the failures The management failed to investigate these warnings 1. March 1992, a senior executive in Singapore expressed his concern on the lack of clear reporting lines 2. Summer 1994, an internal audit cited lax internal controls and made specific recommendations 3. Leeson used an error account to hide his illegal trades – no liaison between markets and company

Recommended Reforms Management teams have a duty to understand fully the business they manage Responsibility for each business activity has to be clearly established and communicated Clear segregation of duties is fundamental to any effective control system

Reforms Continued Relevant internal controls have to be established for all business activities Top Management and the Audit Committee should resolve significant control issues right away Managers should enforce employee job description limits

Nick After Life With Barings Barings Bank collapses Barclays sought to acquire the company but then an additional $300M in losses was added Nick Leeson fled out of London Eventually caught by Interpol in Germany Sentenced 6 and ½ years of prison in Singapore Helped launch PaddyPower.com in summer of 2000, an online betting service

Other Rogue Traders Rusnack lost $690 million for Allied Irish Bank He created false records to cover losses Faces 7 ½ years in prison Management shakeup at AIB This was five years after Baring’s collapse Management is still irresponsible Victims Vs. Idiots

Moral of the Story Something too good to be true probably is just that INVESTIGATE!!! Baring’s Bank was also bailed once before Bad loans in late 19 th Century Financial institutions began noticing that operations will need a dramatic change Top management became targets

Sorry is just not enough sometimes…

Questions?