Financial Meltdowns

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Financial Meltdowns

• IEF 217a Lecture Section 4
• Fall 2002
• Reading Jorion, chapter 2

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(No Transcript)
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Large Insolvencies

• Japan 1990s, 550 billion, 14 GDP
• China 1990s, 498 billion, 47 ???
• US SL, 150 billion, 2.7
• Other banking crises
• Mexico 95, Argentina 80-82, Thailand Malaysia,
  S. Korea
• Most really big crises are overall banking system
  failures

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Derivative Crises

• Increasing over time
• 1990 2 billion
• 1998 28 billion
• Sudden and dramatic events
• Small relative to derivative markets (0.03)

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Derivative Properties

• Tools for
• Hedging
• Speculating
• Often can hide details on risk and positions
• Allow large amounts of leverage

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Case Studies

• Barings 1995
• Metallgesellschaft 1993
• Orange County 1994
• Daiwa 1995
• LTCM 1998

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Barings

• Nicholas Leeson
• Long futures positions on Nikkei
• Loses 1.5 billion as market falls
• How did it happen?
• Lack of back office controls and supervision
• Leesons track recording at the start
• Barings goes bankrupt (shareholders wiped out)
• Leeson goes to jail (now a featured speaker)

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Metallgesellschaft

• Offers long term contracts for oil products
• Should hedge long term, but hedged by rolling
  short term
• Short term drop in oil prices caused short term
  cash flow problems (margin calls on short
  contracts)
• Causes Faulty hedging strategy

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Orange County

• Bob Citron (county treasurer)
• Borrowed at lower short term rates, and lent at
  higher long term rates
• Good strategy while short rates falling
• Track record looks good (750 million to county)
• Short rates rise, fund loses 1.8 billion
• Problems
• Reporting No requirements to report current
  market values
• No one understood the magnitude of the risk

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Daiwa

• Trader Toshihide Igushi loses 1.1 billion
• Losses accumulated over 11 years
• Igushi control both front and back offices
• Allows hiding of trades
• Federal Reserve warnings in 92-93

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Lessons

• Controls
• Reporting
• Risk-management policies

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Responses

• Private
• G-30 (banking), Derivatives Policy Group
• Better oversights and reporting
• JP Morgans Riskmetrics
• Global Association of Risk Professionals
• Financial Risk Manager Certificate Program
• Public
• Financial accounting standards board
• Better balance sheet pricing
• SEC
• Quantitative reporting of risk exposures for
  derivatives