How John Rusnak lost $691 million for Allied Irish Bank

1. How John Rusnak lost $691 million for Allied Irish Bank Sharon Burke April 14, 2003

2. Introduction • $691 million lost in the foreign exchange market • $1 billion profit at AIB for 2001 reduced to $426 million • 5 years of fraud and undiscovered losses • 7 ½ years in prison with $1 million fine • How did this happen?

3. Agenda • Foreign Exchange Concepts • Trading Strategies • The Losses and the Cover-up • Near Misses • Favorite Quotes • Summary

4. Foreign Exchange Markets • Currency bought and sold at exchange rates determined by supply and demand • No central location – dealing rooms in banks and companies • Most foreign exchange trading between banks • London, New York , Tokyo have largest markets • Eurocurrency Market – Borrowing and lending foreign currency

5. Types of Exchange Contracts • Spot Exchange - binding contract to buy or sell a currency for another immediately • Exchange rate is the current spot rate from Reuters • Exchange of monies occurs two days later • Forward Exchange – binding contract to buy or sell a currency for another at a future date • Exchange rate is the forward rate • Forward exchange rate differs from spot rate to reflect interest rate differentials between the two currencies – prevents arbitrage • Monies are exchanged at an agreed upon date • Future – Standardized Forward Contract – amounts and exercise dates are standard – March, June, September, December • Swap – Exchange of currency income streams

6. Currency Options • Gives the holder the right, but not the obligation, either to buy from the option writer, or to sell to the option writer, a stated quantity of one currency in exchange for another • Strike price is a fixed rate of exchange • On a particular date (European) or up to a particular date (American) • Option holder (buyer) pays a premium to the option writer (seller) when the option is written • An option gives the holder the choice to exercise it. • Calls and Puts are available.

7. Background • Allied Irish Bank acquired First National Bank of Maryland (First Maryland) in 1989 • Treasury Department run by David Cronin • Front Office – Trading and investment • Middle Office – Asset and Liability Management and Risk Control • Back Office – operations and verification of Front Office trading • Small foreign exchange operation with trading to hedge for clients at Allfirst

8. Rusnak’s Hedge Strategy • 1993 – Allfirst looking to expand into proprietary foreign exchange trading • Create a niche player in forex to impress AIB • Rusnak promised • to swell profits by trading in options • Consistently make more money by running a large options book hedged in the cash market • Buy options when they were cheap and sell them when they were expensive.

9. Actual Investment Strategy • Directional Trades on the spot and forward markets, mostly on yen and euro. • Occasional use of complex options • 1997 – Currency forwards in favor of the yen increasing in value against the dollar. • Large sum one-way bets were not hedged with reverse option contracts. • Lost money as the yen began depreciating in 1995 and the Asian crisis unfolded.

10. $29.1 million down

11. The Cover-Up • Bogus options • 'Fake docs' • Prime Brokerage Accounts • Value At Risk • Options for Sale

12. Bogus Transactions • Fictitious trades entered in the banks accounting systems appeared to hedge the directional trades. • Bogus trades were entered in pairs that offset each other • Options looked like they had identical premiums in the same currency

13. Example Bogus Trade • Put option is “sold” by Allfirst to a Tokyo bank allowing that bank to sell yen at a specified price – expires on day written • Allfirst “purchases” a Call option from the same Tokyo bank to buy yen at a specified price in the future – has a future expiry date • Rusnak is short a Put, long a Call and long a forward contract. • Payoff diagram is a straight line with positive slope

14. Bogus Transactions (continued) • The put option that was "sold" expired on the same day written. The liability of it went off the books immediately. • The call option that was "purchased" stayed on the books as an asset of the bank. The value of the option covered the losses. • Two options were necessary so the received premium and the paid premium canceled out.

15. Bogus Transactions (continued) • The treasury back office was responsible for the net settlement and would take notice if the options did not net out. • Different expiration dates result in different option prices. • Deep-in-the-money Put option would have been exercised. • When a Call option reached it’s expiry date, it was rolled into another bogus option.

16. Fake Docs • Every trade at the bank was required to be independently confirmed by the Treasury back office. • Rusnak used his PC to create false trade confirmation documentation. He called the file on his computer "fake docs". • Mail Box Etc. to fake Fax confirmation • Rusnak bullied the back office into not confirming Asian trades that netted to zero.

17. Fake Docs (continued) • Allfirst's trade confirmation practices were outdated - phone and fax. • Back office staff did not relish coming in at night to confirm Asian trades. • Large banks with foreign trade departments used Crossmar Matching System which confirms trades in minutes. • Allfirst did not feel Crossmar was worth the investment given they had only two traders in foreign exchange.

18. $41.5 Million Down

19. Prime Brokerage Accounts • High profile trading accounts typically used by hedge funds. • Daily spot transactions are rolled into one forward transaction to be settled at a future date with the prime broker. • Expand the scale and scope of trading to large volume high value currency trades. • Relieve the back office of work. • Make Rusnak’s bonus bigger.

20. Prime Brokerage Accounts • Fictitious Prime Brokerage transactions in the Devon accounting system • Entries were reversed before month end reconciliation to hide losses • High risk 'historical rate rollovers" used • Gains or losses rolled over into a new contract at the historical rate of exchange • Warned against by Federal Reserve Bank of NY foreign Exchange Committee

21. $90 Million Down

22. Value at Risk • Main method used by banks to monitor traders activities • Largest loss the bank anticipates given adverse trading conditions • Calculated using the 'Monte Carlo' simulation technique to generate 1000 hypothetical rate fluctuations and the resulting profit or loss • The Value at Risk (VaR) is the 10th worst outcome for the portfolio • Rusnak's limit was $1.5 million

23. Value at Risk Manipulation • Bogus options appeared to hedge his real positions • Entered forward transactions in Devon but reversed them before monthly settlement • Hid his large open currency positions by supplying his own values in a spreadsheet

24. Value at Risk Manipulation (continued) • Manipulated currency rates to make it look like he had not exceeded his monthly $200,000 stop-loss limit • Exchange rate data from Reuters was fed directly to Rusnak's PC • Rates were then fed from a spreadsheet on Rusnak's computer to the bank's database.

25. Value at Risk Manipulation (continued) • Treasury back office was supposed to independently confirm the exchange rates. • "...the bank would not pay $10,000 for a data feed from Reuters to the back office due to the bank's cost cutting drive." • Up until April 2001, Rusnak manipulated rates using this system.

26. $300 Million Down

27. Balance sheet usage • Balance sheet usage was coming under scrutiny in January 2001 • Foreign exchange trading revenue was $13.6 million while net trading income was $1.1 million • Management wanted use of the balance sheet, use of cash, reduced • Rusnak's solution was to sell deep in the money options to raise money

28. Options for Sale • Options were sold with deep-in-the-money strike prices • Rusnak received large cash payments in the millions of dollars for these options • Strike prices were extremely unlikely to be reached so Rusnak would most likely owe • Yen puts against the dollar • European option that expired in a year to give Rusnak time to win the money back

29. Citibank's Deal • $125 million in cash for a strike rate of 77.37 yen to the dollar in return for an option that would expire in a year and a day • Yen at the time was 116 to a dollar • Dollar would have to fall 35% or more for the option not to be exercised • Option was effectively a high interest loan

30. Options for Sale (continued) • Huge up front premiums in exchange for high interest rates • Rusnak sold $300 million worth of these options • Liabilities that needed to be hidden in Allfirsts books • Rusnak recorded false deals that made it look like the options had been repurchased

31. $674 Million Down

32. Near Misses • 1999 - Risk Assessment auditor questions Rusnak's over limits • March, 2000 - Citibank questions Allfirst's ability to settle a $1 billion prime account • March 2000 - Rusnak gets Travel Bloomberg software to trade at home and on vacations despite this being a violation of US law. • March 2000 - SEC 10k filings reveal Allfirst's foreign exchange trading is in the billions of dollars.

33. Near Misses (continued) • August, 2000 - An internal audit of treasury checked trading confirmations. They checked one out of 60+ trades and by chance picked a valid one. 30+ were fake. • August, 2000 - Rusnak exceeds a $1 million credit limit by $86 million. Investigation reveals "trader error".

34. Near Misses (continued) • January, 2001 - When asked to confirm a bogus option by auditors, Rusnak sets up a fake mailbox in Manhattan and has fake confirmations faxed to the office. • Early 2001 - Rusnak threatens to pull business from Bank of America over an exchange rate dispute on "synthetic loan" • April 2001 - Foreign Exchange rate spreadsheet is found to be corrupt.

35. Near Misses (continued) • June 2001 - AIB CEO questions size of foreign exchange operation. • October 2001 - SEC questions size of Allfirst's cash flow in regards to foreign exchange. • December 2001 - Treasury Back Office supervisor realizes Asian trades are not being confirmed. • January 2002 - Annual report shows $100 million in open positions. Rusnak calls this a mistake.

36. Favorite Quotes • "We would never have gone off betting the dollar against the yen. We weren't Citicorp. It didn't make any sense." - former First Maryland executive. • "If Rusnak had the luck in the markets that he had avoiding detection, …” • "...the biggest Foreign Exchange trader in North America was working out of Allfirst“

37. Favorite Quotes • "How could a little bank like that be trading in amounts like that?" said a businessman having his hair trimmed at Cheryl's Salon, round the corner from the headquarters of Allfirst Financial • An Allfirst customer withdrawing cash from the machines in the bank's lobby, was worried that if the bank could "lose that sort of money, then what are they doing with mine?" • "Who's minding the shop at that place?"

38. Summary • Rusnak lost money and covered the loss in hopes he could “win it back”. • Technology lapses in the bank were optimized to hide losses • Regular internal audits did not take place • Back Office monitoring of trades was ineffectual • Politics between AIB and Allfirst interfered with monitoring Rusnak’s activities

39. Resources • Report to the Borad of Director’s of Allied Irish Banks, P.L.C., Allfist Financial INC.,and Allfirst Bank Concerning Currency Trading Losses – Submitted by Promontory Financial Group and Wachtell, Lipton, Rosen & Katz – March 12, 2002 • Panic at the Bank – by Siobhan Creaton and Conor O’Clery • www.aib.ie • Foreign Exchange Markets – Brian Coyle • Currency Options – Brian Coyle • Trading in Currency Options – William Sutton • New York Times • Financial Times – www.ft.com