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Analyse the causes of, and lessons from, these financial disasters: the 1980s US savings and loan crisis, Lehman Brothers, Continental Illinois, Northern Rock, Metallgesellschaft, Niederhoffer, LTCM, the London Whale, Barings, Bankers Trust, Orange County, Sachsen Landesbank, Volkswagen, Enron and SWIFT.

FRM® Part I · Foundations of Risk Management · Learning from Financial Disasters · FRM1.FR.9.a

The idea

Each case teaches a distinct failure, and the exam asks you to match case to cause. Barings (1995): one trader controlled both trading and settlement and hid losses in an error account, so segregation of duties failed. Orange County (1994): a treasurer levered a pool with reverse repos and structured notes, a bet that rates would stay low. Bankers Trust (1994): complex leveraged swaps sold to Procter and Gamble and Gibson Greetings, a sales-practice, legal and reputation failure. Metallgesellschaft (1993): a rolled short-dated futures hedge of long-dated fixed-price contracts caused margin-call funding strain. Niederhoffer (1997): leverage and a short-option position whose tail loss exceeded the fund's equity. LTCM (1998): highly leveraged convergence trades, with correlations and liquidity breaking down and many holders of similar positions selling at once. London Whale (2012): model risk and weak governance. Continental Illinois (1984), Northern Rock (2007), Sachsen LB (2007) and Lehman (2008): funding and liquidity runs. Savings and loans: duration mismatch and moral hazard. Enron: off-balance-sheet entities and governance. Volkswagen (2008): a short squeeze. SWIFT (2016): cyber-enabled operational risk.

A practice question

From the question bank, with the reason each wrong option is wrong.

What was the principal source of the 1994 losses in the Orange County investment pool?

  1. Unhedged foreign-exchange exposure on euro-denominated bonds that lost value when the dollar strengthened sharply.Why not: Invents an FX exposure; the pool's problem was interest-rate risk and leverage.
  2. Unauthorised trades concealed in a fictitious account by a derivatives trader.Why not: Confuses Orange County with Barings, which involved concealed unauthorised trading.
  3. A levered pool funded with reverse repos and holding structured notes that fell in value when rates rose. - correct
  4. A short position in a thinly traded equity whose price was driven up by a squeeze.Why not: Confuses Orange County with Volkswagen, where short sellers were squeezed.

Treasurer Robert Citron levered the pool with reverse repos and structured notes, a bet that rates would stay low. When rates rose in 1994 the losses forced the county into bankruptcy.

A harder one

A firm has sold fixed-price delivery contracts for 50 million barrels of oil over ten years and hedges them, as Metallgesellschaft did, with a stack of near-month futures on 50 million barrels, rolled monthly. Oil falls by USD 6 per barrel. Ignoring interest, what variation margin must the firm post in the first month?

  1. Zero, because the delivery contracts gain exactly as much as the futures lose, so there is no net cash requirement.Why not: Treats an economic hedge as a cash-flow hedge, ignoring the timing mismatch.
  2. USD 30 million, because only one tenth of the volume is hedged by futures in any one year.Why not: Divides by the ten-year horizon, but the stack hedge holds the full volume in front-month futures.
  3. USD 150 million, because a hedge ratio of 0.5 is typically used for a long-dated exposure.Why not: Applies an unstated hedge ratio of 0.5 instead of the 1:1 position given.
  4. USD 300 million, a cash outflow now, while the offsetting gain on the delivery contracts is unrealised and arrives over ten years. - correct

Loss is 50 million x USD 6 = USD 300 million, paid in cash immediately via margin. The gain on the fixed-price contracts is realised only as oil is delivered. This funding-liquidity mismatch forced MG's parent to liquidate.

The hardest tier

A risk manager reviews a highly leveraged hedge fund with many convergence trades across markets, as LTCM had. VaR from two calm years shows low risk and strong diversification. Which statement best explains why that comfort proved false for LTCM in 1998?

  1. The fund held mainly Russian government bonds, so diversification was never present and the Russian default was the only driver.Why not: Wrongly claims concentration in one asset class; LTCM's positions were spread across markets.
  2. The fund hedged long-dated liabilities with rolled near-month futures, and margin calls on the hedge exceeded its capital.Why not: Confuses LTCM's convergence trades with Metallgesellschaft's stack-and-roll hedge.
  3. Correlations and spreads estimated in calm periods broke down in a flight to liquidity as many holders of similar trades sold at once, and high leverage turned a modest adverse move into forced liquidation. - correct
  4. The losses came from unauthorised positions concealed from the risk manager, so VaR was never based on true holdings.Why not: Confuses LTCM with a rogue-trader case; LTCM's positions were known to its partners and lenders.

LTCM's VaR relied on calm-period history, so it missed the correlation breakdown and liquidity squeeze after the August 1998 Russian default. Leverage forced liquidation, and a Fed-organised private rescue by creditor banks followed. Lessons: liquidity risk, stress testing, leverage.

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