Financial weapons of mass destruction – derivatives disasters in Australia

 Welcome to Finance and Fury, the Furious Friday edition.

This episode – will be looking at derivative disasters through in the history – looking at specific crashes of near financial disasters – that were contained

Specifically – Look at a few examples in Australia –ones that most people wouldn’t have heard about – been studying derivatives and the legislative side to them over the past few weeks – came across cases that I had never heard of – wanted to share this and help to demonstrate how these instruments when misused can create a fragile financial system

To start with – Financial derivatives are powerful instruments

1. Mainly because of their capacity to operate with a high degree of leverage -Therefore a small change in underlying prices of the assets that they are written on can lead to dramatic profits – but also losses
   1. Due to counter party risks – i.e. the other person that you enter these contracts into with – ones gains can be another loss – and when the loss comes due – the counter party can come knocking – but this is a simple bilateral arrangement – gets more complicated when these are millions of contracts spread between just a few providers
2. I’m sure that a lot of people listening would have heard of Warren opinion of financial derivatives – that they are financial weapons of mass destruction
   1. However – the irony is that in the BH annual report to shareholders the same year that this statement was uttered – the firm disclosed that they used derivatives to execute some investment strategies – these actions illustrate the usefulness of derivatives to hedging and arbitrage operations
   2. The spread of these instruments means that they will continue to be accepted and used both by financial experts and consumers – no getting rid of them  
3. Have been around for a while – Derivative history – first created in In September 1987 – there was a collapse in most major share indices
   1. Within hours of this crash, international emergency meetings had been convened by Alan Greenspan introducing a “solution” – The creation of a new instrument – this was called a “Creative financial instruments” but otherwise known as “derivatives” today – Came up with the derivative instruments as a concept and further increased the risk to the financial system

Looking at these Derivative disasters in context – what similar elements they have

1. Important to run through – as before we discuss specific derivatives disasters – need to recognise that each of these issues in the context of a broader range of financial disasters do have similar elements
   1. No shortage in financial disasters – they have a long history – many different causes linked to a wide range of stemming issues – for instance – changes in financial climates – downfalls of empires – systemic banking crises fuelled by overleverage – as well as human error, negligence and fraud
   2. Now – derivatives do not the pure cause of financial disasters – but their characteristics of leverage and structural opaqueness in pricing, means that they add an element to a normal financial crash – in that they accelerate and eventuate the existing risks that are inherent in the fragility of any economy and financial markets
2. That is the common element of derivatives disaster – they increase the risks of downturns happening and amplify the level of those downturns
   1. The profile of derivatives disasters cuts across all types of users, including banks, public companies and even government agencies
   2. Most of these stem from banking institutions – they are the champions (and sellers) of derivatives – and are therefore not immune to error – or negligence and fraud in selling and managing these derivative products –some of these downturns were purely due to one rouge trader – shows the power of these instruments when misused – however – things become far more risky when the whole industry is swept up in the perception of easy gains and everyone jumps on the same bandwagon – fuelled by competition and greed
   3. Disasters occur when there are failed attempts at the three major area that derivatives are used – Hedging, Arbitrage and Speculating – most obvious for risk taking
3. The other common element of derivatives disasters – the Major issue that predicting financial downturns face is due to the range and breadth of these instruments – hence – disasters are not restricted to any one asset class or commodity
   1. there is a wide cross-section of asset class derivatives – including foreign exchange, interest rates, commodities, bonds, housing, mortgage and equity derivatives
   2. There are no cultural or geographical biases in derivatives disasters. They can combust anywhere and at any time when not treated with care
   3. This creates a stem of counter party risks – the spread of risks through the whole system
   4. Think about shares – bubbles are contained to shares – easier to spot – but the derivative markets are all encompassing on all assets

Looking at one of the first cases in history of derivatives loses –

1. Occurred in Australia in 1987 – This comes from a company called AWA and their foreign exchange losses – not long after the invention of these instruments
2. Backstory – in the early 1980s – Australia went through with the deregulation of the banking and financial system –
   1. Then – by December 1983 – the floating of the Australian dollar was introduced
   2. These two factors opened the door for an explosion in the use of speculation – specifically – the introduction of derivative products – originally these were used for risk management purposes
   3. However – the euphoria of these new entrants to the market created a situation where companies would speculate on their hedges for risk management purposes – ironically kind of defeated the purposes – but the financial industry’s exhilaration saw derivative use expand into what was referred to as out-and-out speculation – also called ‘hedgulation’ – the act of speculating with one’s hedges)
3. One of the very first examples of this going wrong was with AWA Limited (AWA) – this is an Electronics company that began operations in Australia in 1913
   1. In March 1987 – hit the headlines as their financial results showed that a third of its earnings came from the foreign exchange spot and derivatives dealings
      1. Remember – this is an electronics business – But these profits came from their 24-year-old treasurer – named Andy Koval.  
   2. Obviously – at the time Andy was seen a whiz-kid – a market genius – but this was short-lived
      1. Four months later – AWA determined that these forex earnings might have been overstated – as now the positions had gone bad and it was facing a $30 million loss – once the positions were closed up this was later revised to a $50 million loss
      2. Andy Koval was then dubbed a ‘rogue trader’ – and the company dismissed him and all the layers of management above him but no directors were fired
   3. The case went to court with the damages suit filed by AWA against its auditor, Deloitte – this was also important as it became a landmark case, essentially a precedent for the differing duties of auditors, senior management and non-executive directors to prevent such debacles – even though in practice it did little
      1. In the court case –Justice Andrew Rogers found AWA had no internal controls over foreign exchange dealings and the books and records were as he quotes “a shambles”
      2. But AWA claimed that Deloitte as its external auditor – was responsible for $50 million in losses incurred by their treasurer – Andy Koval

• The end result of the case was that the damages were reduced down to $6 million – where AWA’s liability was at 33.33% ($2m) and Deloitte’s was 66.66% ($4m)

1. Concerning the use of derivatives in Australia, this was one of first high-profile cases dealing with mishandling of risk exposure hedging – but not the last  

1. This loss revealed some core components the issues with derivatives 
   1. a lack of internal controls over delegation and competent management oversight – few people understand these instruments – and fewer still know how to manage them appropriately – and even those that do can lose big if the position turns against them
   2. excessive hedging of exposures – essentially the large leveraging potentials -with open hedges in this case equal to 400% of yearly US$ payables – or over 4 times the maximum that was needed  

• that the accounting standards were insufficient to inform and protect investors – and nothing has really changed here – the reporting standards still tend to use value at risk (net positions) rather than the notional values – which are magnitudes higher

1. Currency exposure management when using derivatives can be as risky as the underlying risks they are meant to handle – technically if done incorrectly, even more so

4. But this loss of $50m seems miniscule compared to where the market would head over the next 20 years to 2007 – in todays value – around $126m – still a large loss for one company to make
   1. However – important to remember – this was simply off mishandling a currency hedge

The next financial mishap with derivatives was with National Australia Bank in 2003/04

1. This came from option trading losses – again on currency positions – and similar to AWA – came from a ‘star’ trading team – they were generating large returns – so no need to look any closes – they were making profits on paper do don’t ask any questions on how
   1. However – they were in reality – concealing mounting losses on a short AU$–US$ option position
   2. They started in 2003 by entering false transactions into the bank trading system
2. They used various methods that exploited operational and technological gaps in controls – falsifying records – turns out it was relatively easy to do –  
   1. They would either incorrectly record genuine transactions or simply enter false transactions or use incorrect exchange rates.
   2. By the time this was discovered – they had accumulated losses at around AU$180 million the following year
   3. Now came the clean-up process – as you have to exist your positions – and to do so you need to sell them off to other financial intuitions (at a lower rate than what you purchased them for) or pay out the losses on the contracts
3. By the time this was all said and done – there was a total loss of around AU$360 million
   1. Again – the use of foreign exchange derivatives took central stage in the scandal
   2. This however was purely due to operational risk – rather than being caused by an incidence of market collapse or a funding or credit risk – it was purely due to no real oversight on the trading team – hence a massive failure known as operational risk  
   3. All of this showed that NAB had a massive lack of financial controls and had significant gaps in their procedures – with a failure to manager their systems to supervise FX teams –
   4. Not to just single out NAB – they simply had the last element of a lack of integrity in the people involved – could have happened at any bank or financial institution – it was just the people at NAB were the bad eggs

Summary –

1. Each of these examples were relatively small in comparison – what they were trading on was the exchange rate – the movements – the underlying assets didn’t go to worthless –
2. Also highlights the need for the managers of these companies to understand the intricacies of proprietary trading before it is undertaken
   1. I covered the concept of proprietary trading in an episode on this a few weeks ago – concept of a firm trading their own assets for profit – or in this case writing derivatives on them – was banned after GFC in US but was recently repealed – so game on again
3. These two examples show that on a smaller scale – derivatives do have a practical use – however – as they are powerful instruments – their financial and operational risks are also potentially huge if mismanaged –
   1. most of the derivatives courses I did at uni were about hedging risks – what contracts that BHP should take with their Chinese supplies to offset any currency risks – do provide businesses with a hedging tool – but also allows speculation and greed to be implemented in a massive way
4. now that some of the smaller cases are out of the way – Next week – examine some derivative disasters during and after and GFC – follow the story of a depressing repetition demonstrating an industry-wide amnesia about the risks of derivative use – but one that everyone should be aware of

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