By Anuj Jain Suresh Attal Diana Cho Alice Kim

1. 88888: “Five Fat Pigs” By Anuj Jain Suresh Attal Diana Cho Alice Kim

2. Introduction • February 26, 1995 • Baring Brothers & Co. collapsed, reducing in value from $500 million to $1.60 • The culprit • 28 year-old rogue trader, Nicholas Leeson • By secretly traded futures contracts on both the Nikkei 225 and on JGB’s (Japanese Government Bonds) • The damage • $1.4 billion dollars lost

3. Leeson’s Responsibilities • Leeson was authorized to take advantage of arbitrage opportunities available in Osaka and Singapore futures markets on the Nikkei 225 • Leeson chose to ignore the strategy which he was supposed to employ • The secret 88888 account • Used to hide the losses

4. Leeson’s Trading Strategy • Went long on Nikkei 225 future contracts • Used the option premiums to offset his needs for margin requirements from futures contracts • Also went short on Japanese Government Bonds to hedge his exposure partially.

5. Leeson’s Trading Strategy • As losses mounted he took on larger positions – Rogue Trader • Other traders choose to take advantage of the big position that Barings had to bet against the firm • To stem losses, Leeson would step in to support the market causing him to continue to build up more positions

6. Tally Sheet • By February 23, 1995, Leeson held: • 49% total open interest in Mar ’95 Nikkei futures • 24% total open interest in Jun ’95 Nikkei futures • 88% total open interest in Jun ’95 JGB futures • 5% open interest in June ’95 Euroyen futures • Adds up to MASSIVE MARGIN CALLS for Baring’s

7. Leeson’s Plan • Leeson placed bets on the direction of price movements on the Tokyo stock exchange • Focus: Count on the Nikkei index to rise • Felt that the Nikkei had fallen too much and expected it to rebound eventually • If it did rebound he would have made a profit on: • The increased stock value • An increase in interest rates

8. Selling Options a. Sell Call b. Sell Put c. Sell Straddle Profit Profit Profit • Leeson used straddle approach • Option expires “out-of-the-money”  profit • However, as price volatility increases, an option seller’s potential losses are unlimited strike price strike price strike price

9. The Worst Possible Scenario… January 17, 1995 Violent earthquake hit Kobe, Japan • Nikkei fell 1,500 points • Leeson’s options lost ₤68 million • PLAN B - Tried to sustain market by: • Buying massive amounts of Nikkei stock index futures • Selling Japanese government bond futures, betting that interest rates would rise

10. Concealed Trading Losses

11. Where Did It Go Wrong? WEAK BALANCE • Mostly gambled on direction of markets. • A major part of Leeson’s trading strategy involved the purchase of futures on Nikkei-225 futures contracts • His only “hedge” was in holding a short position on JGB’s. • He only made a one-sided bet.

12. The Failure of Internal Controls • No clearly laid down reporting lines • Several managers responsible for monitoring Leeson’s performance did not do their job • No segregation of front and back office activities • No comprehensive review of Leeson’s funding requirements

13. The reason for the failures • The management failed to investigate these warnings • March 1992, a senior executive in Singapore expressed his concern on the lack of clear reporting lines • Summer 1994, an internal audit cited lax internal controls and made specific recommendations • Leeson used an error account to hide his illegal trades – no liaison between markets and company

14. Recommended Reforms • Management teams have a duty to understand fully the business they manage • Responsibility for each business activity has to be clearly established and communicated • Clear segregation of duties is fundamental to any effective control system

15. Reforms Continued • Relevant internal controls have to be established for all business activities • Top Management and the Audit Committee should resolve significant control issues right away • Managers should enforce employee job description limits

16. Nick After Life With Barings • Barings Bank collapses • Barclays sought to acquire the company but then an additional $300M in losses was added • Nick Leeson fled out of London • Eventually caught by Interpol in Germany • Sentenced 6 and ½ years of prison in Singapore • Helped launch PaddyPower.com in summer of 2000, an online betting service

17. Other Rogue Traders • Rusnack lost $690 million for Allied Irish Bank • He created false records to cover losses • Faces 7 ½ years in prison • Management shakeup at AIB • This was five years after Baring’s collapse • Management is still irresponsible • Victims Vs. Idiots

18. Moral of the Story • Something too good to be true probably is just that • INVESTIGATE!!! • Baring’s Bank was also bailed once before • Bad loans in late 19th Century • Financial institutions began noticing that operations will need a dramatic change • Top management became targets

19. Sorry is just not enough sometimes…

20. Questions?