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History and News

Continued from page 4

A History of the New York Stock Exchange and America's Financial Markets



Many of the financial debacles of the recent past are a direct result of the tendency of financial institutions to place too much authority in the hands of literally unsupervised traders. Nick Leeson, a 28 year old purported whiz kid, engineered the demise of Barings PLC, the oldest merchant bank in Great Britain (founded in 1762), devising a flawed electronic trading system and covering it up through forgery and lies. () Initially, Lesson’s primary interest was speculatively arbitraging the 10year Japanese Government Bond against the highly volatile Nikkei225 stock index futures and options. As time went on, he graduated to unhedged bets on the direction of the Tokyo Stock Exchange. Leeson lost almost immediately and had accumulated a loss of almost $4 million within several months.

In addition to supervising the trading department of Barings' Singapore operations, Leeson was also responsible for overseeing settlements. Thus, in his dual role, he could manufacture fictitious reports. By the end of 1994, his losses already exceeded Barings' profit. For the most part, Leeson was brought down by the Kobe Earthquake, which decimated the Japanese Stock Market. In his final trading hours, at one point, he was able to control over 88 percent of the open interest in the June Contract for Japanese Government bond futures. Leeson gave the market adequate warning by being the central figure in other contracts as well.

Even massive margin calls did not create concern on the part of Barings' management (). It was only the fact that irregularities appeared on the Singapore Settlement's books that the home office became concerned. When these discrepancies could not be resolved, and Leeson was asked to explain, then and only then, did the roof collapse. Barings' loss, a staggering $1.4 billion. The markets became erratic, prices fell, margins were raised and the aftershock produced dislocations all over the globe.

Toshihide Iguchi, when in his formidable years, was regarded as a wunderkind. Like Leeson, Iguchi developed a global reputation as the "King Midas" of copper while at Sumitomo and established a department in which his reporting requirements to his superiors was minimal. He was able to continue his charade for many years through forgery and lies while inspiring losses of $2.6 billion for his employer. His Japanese firm has been banned from the United States not only for committing the crime in the first place, but also for attempting to cover it up by corporate criminal actions.

Mr. Iguchi is no longer trading copper but his legacy has succeeded him. In spite of The London Metals Exchange (LME) along with the New York Mercantile Exchange (the major markets in which cooper is traded) institution of constructive reforms, primarily dealing with the market’s transparency, volume has floundered and leadership has unearthed greener pastures. Other metals have replaced cooper as "big ticket" items () and it will probably be years before the copper markets regain their luster of old.

Joseph Jett, a young trader at Kidder Peabody, an old line Wall Street Company, was directly responsible for sending his firm into oblivion. A series of nonexistent electronic transactions threw Kidder’s books into such disarray that auditors still have not been able to trace his transactions with any degree of assurance. This incident may be of critical interest to those who come from "it can’t happen here university". General Electric, a company that is considered by securities markets to be the most valuable company on earth, owned kidder. The financial community is convinced that they achieved this distinction due to the extraordinary management talents of their senior people. As opposed to others, General Electric operates in a "hands on" mode and theoretically could get away with it only because their controls were believed to be almost flawless. Why then, if we are not looking at a major problem, was General Electric forced into a position to write off over $2 billion in losses? What makes this case even more critical is the fact that General Electric not only overlooked what Jett was doing, but was also negligent in evaluating the machinations of his superiors as well. At the time these traders received the authority to bet the house in the biggest electronic crap game on earth, their average age was 23 ().

The fact that these gentlemen were young and unsupervised when they started down their path to electronic theft is not the only common ground they shared. In each case, the transactions were highly complex (derivative based) and unless a key was available to unlock the code, it would have been nearly impossible to decipher what had transpired. () Maybe of even greater importance, substantial bonuses await the successful traders that rack up big profits for their employers. The prestige and wealth that accompany top rate performance are as addictive as an opiate.

These examples are only a few among many: Peter Young of Deutsche Bank easily held his own when it came to unauthorized losses that he illegally racked up to the tune of $600 million; Colin Armstrong, fund manager for Hong Kong operations of Jardine Matheson, created transactions that allowed him to directly pocket untold millions of his client’s money; and, in a case similar to the Jet fiasco, National Westminster Bank is still trying to sort out its books after finding that a trader adjusted his transactions at bonus time to the tune of well over $100 million.

Another young man who successfully cooked another set of books was Kevin Wallace, former Merrill Lynch & Co. all-star. Mr. Wallace’s legitimate income from Merrill was probably in access of $10 million. His claim to fame was a winning personality, excellent sales skills and some knowledge of the market place. His methodology was simplistic; no derivatives or currency spreads for our Mr. Wallace. Just two sets of books, one sent out to clients by Merrill and another fashioned by Wallace, which showed sensational profits in his client’s accounts. When asked about the discrepancies between the two highly differing accounts of customer activity, our hero would respond that Merrill wasn’t really very good a bookkeeping and that their computer was usually out of order. His figures were "accurate and could be relied upon". Inexplicably, almost to a person they accepted the highly credible Wallace’s bizarre story.

For Wallace, if he is ever found, things could become difficult, for Merrill, the affair is a powder keg. Wallace’s client’s represented a substantial part of the wealth in Southeast Asia. Not only that but Wallace was fired for other reasons some time ago and the affair only came to light when he was retired from the "bookkeeping by mail business" and his client’s were left with only one set of books to rely upon. Merrill never noticed the problem until it was called to their attention by what soon became a chorus of wounded investors. What made matters even worse is the fact that many of the investors, not satisfied with Merrill’s offer of the return of principal and interest, are requesting the profits that Wallace had promised as well.

Supervision at Merrill has been a substantial question, in any event, after the ill-fated Orange County fiasco, and when you raise additional questions as to Merrill’s internal controls, you are making an excellent case for avoiding them like the plague. We are not sanguine about Merrill's future role in this part of the globe if they can’t get their act together.

The potential for economic damage from derivative trading knows no national boundaries. () Metallgesellschaft Refining and Marketing (MGRM) the American subsidiary of Metallgesellschaft AG (MG), actualized a nearly $2 billion fiasco as a result of a sound business concept that, because of its complex nature, had to be converted into a derivative to function. Ultimately, the sheer complexities of the transaction became unfathomable to the participants, who prematurely unwound positions that have been characterized by some as sound. ()

The scheme was simple, "In 1992, MGRM began implementing an aggressive marketing program in which it offered long-term price guarantees on deliveries of gasoline, heating oil, and diesel fuels for up to five or ten years. This program included several novel contracts, two of which are relevant to this study. The first was a "firm-fixed" program, under which a customer agreed to fixed monthly deliveries at fixed prices. The second, known as the "firm-flexible" contract, specified a fixed price and total value of future deliveries, but gave the customer some flexibility to set the delivery schedule. Under the second program, a customer could request 20 percent of its contracted volume for any one-year period, with 45 days' notice. By September 1993, MGRM had committed to sell forward the equivalent of over 150 million barrels of oil for delivery at fixed prices, with most contracts for terms of ten years." ()

Two additional elements of the program were that they received a premium of $3 to $5 per barrel over the then spot price and prices, at the time, were historically low. Management of MGRM and its customers were convinced that prices would rise in the ensuing years and that the premium represented a small insurance premium on future prices. MGRM insured its ability to make delivery by purchasing oil in the forward markets in quantities comparable to its customer purchases. MGRM would acquire a large clientele on a very profitable basis while insuring that it had optimized its total return.

The Company’s optimum scenario failed for all of the wrong reasons: oil did not immediately rise, it collapsed. MGRM’s poorly constructed hedge contained dissimilar elements and when liquidation of the position was commenced the derivatives () lost their collateral value. Margin calls were issued and it was the determination of MG that unless the positions were immediately unwound, they would go bankrupt. The end result was the largest loss ever suffered by a business to that point in time, the near dismantling of MG, disorientation and the collapse of the oil markets as the positions were liquidated. This occurred in a situation that only became calamitous because it could not be understood.

Derivatives' trading is not for the faint of heart or the uninformed. Without total knowledge of the markets and particular objectives, without proper supervision and controls, and without finite ability to determine risk reward, it is a fool’s game. In spite of this, early in the 1990s, Bankers Trust, a "wholesale banker" began preaching the "derivative gospel". Effectively they were telling large multinational corporations such as Procter and Gamble (), Gibson Greeting Cards (), Air Products, Sandoz, and Federal Paperboard the derivative hedges could be set up to level peaks and valleys in various aspects of these company's business. () The aforementioned clients of Bankers Trust purportedly wound up losing substantial sums as a direct result of this derivative trading. ()

The behind the scenes scenario was played out somewhat differently. Consider, for example, oral references by Bankers Trust (BT) staff to a "rip-off factor" that was attached to complex deals involving leveraged derivatives. One BT salesman describes how he would "lure people into that total calm and totally fuck them." Perhaps worst of all, a video shown to new employees includes a telling description by a BT instructor of how a swap works: he says that BT can "get in the middle and rip the [the customers] off". Remembering that cameras were rolling, the instructor then apologized. BT says the episode was a poor and inappropriate attempt at humor." ()

Well if you can't trust Bankers Trust, then who can you trust? The World is spinning at an ever-increasing crescendo, the European Markets could shortly be merged as will be their currency. The markets in Asia are in free-fall, Japan looks like it is in some serious trouble, Hong Kong is part of China and the world has become attached at the waist by a thing called Internet that seems to convey information at the speed of light. Computers are outperforming Moore's Law and if you don't have a scorecard, you really don't know where you are. Exchanges are going global and the regulations that took so long to evolve are going out the window. Even the Securities and Exchange Commission says that they are going to leave the electronic market place alone, for now. As if they could do anything about it anyway. Times were a lot simpler under the Buttonwood tree even when people weren't buying stocks.

This remains to be seen and we are far from sanguine of how good these will be.

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