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Financial Meltdowns

Explore the devastating financial meltdowns of the past, including large insolvencies in Japan and China, as well as other global banking crises. Dive into the world of derivatives and their role in these meltdowns, examining case studies such as Barings, Metallgesellschaft, Orange County, and Daiwa. Learn valuable lessons on controls, reporting, and risk management in order to prevent future crises.

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Financial Meltdowns

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  1. Financial Meltdowns IEF 217a: Lecture Section 4 Fall 2002 Reading: Jorion, chapter 2

  2. Large Insolvencies • Japan 1990’s, $550 billion, 14% GDP • China 1990’s, $498 billion, 47% ??? • US S+L, $150 billion, 2.7 • Other banking crises: • Mexico 95, Argentina 80-82, Thailand + Malaysia, S. Korea • Most really big crises are overall banking system failures

  3. Derivative Crises • Increasing over time • 1990: $2 billion • 1998: $28 billion • Sudden and dramatic events • Small relative to derivative markets (0.03%)

  4. Derivative Properties • Tools for • Hedging • Speculating • Often can hide details on risk and positions • Allow large amounts of leverage

  5. Case Studies • Barings 1995 • Metallgesellschaft 1993 • Orange County 1994 • Daiwa 1995 • LTCM 1998

  6. Barings • Nicholas Leeson • Long futures positions on Nikkei • Loses $1.5 billion as market falls • How did it happen? • Lack of back office controls and supervision • Leeson’s track recording at the start • Barings goes bankrupt (shareholders wiped out) • Leeson goes to jail (now a featured speaker)

  7. Metallgesellschaft • Offers long term contracts for oil products • Should hedge long term, but hedged by rolling short term • Short term drop in oil prices caused short term cash flow problems (margin calls on short contracts) • Causes: Faulty hedging strategy

  8. Orange County • Bob Citron (county treasurer) • Borrowed at lower short term rates, and lent at higher long term rates • Good strategy while short rates falling • Track record looks good ($750 million to county) • Short rates rise, fund loses $1.8 billion • Problems: • Reporting: No requirements to report current market values • No one understood the magnitude of the risk

  9. Daiwa • Trader: Toshihide Igushi loses $1.1 billion • Losses accumulated over 11 years • Igushi control both front and back offices • Allows hiding of trades • Federal Reserve warnings in 92-93

  10. Lessons • Controls • Reporting • Risk-management policies

  11. Responses • Private • G-30 (banking), Derivatives Policy Group • Better oversights and reporting • JP Morgan’s Riskmetrics • Global Association of Risk Professionals • Financial Risk Manager Certificate Program • Public • Financial accounting standards board • Better balance sheet pricing • SEC • Quantitative reporting of risk exposures for derivatives

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