Picking Up the Pieces : The Critical Blunder That Brought Down a British Institution

As regulators, executives and markets try to sort out the futures and options trading that brought down Barings, the institution’s critical blunder is becoming increasingly clear.

The bank made 28-year-old Nicholas W. Leeson responsible not only for trading futures and options in its Singapore office, but for “clearing”--that is, reconciling the firm’s holdings with its books.

That setup was akin to giving your child access to your checking account as well as the job of balancing your checkbook: The risk is that you won’t know what he’s spent until the bank statement comes in the mail.

Reports from London-based Barings say that moment arrived for the bank several days ago, when Leeson told superiors he needed more money to cover losses in his futures holdings on Far Eastern exchanges. Mystified over why he had run out of cash, the bank sent an auditor, who discovered losses that are now expected to top $1 billion.

Futures experts say the unusual arrangement in Singapore may have permitted Leeson to keep his positions obscure for far longer than they might otherwise have remained. Most institutions maintain an unbreachable wall between the so-called front office and back office--the traders and the record keepers. At Barings, however, both functions were in Leeson’s hands, although he reported to at least two superiors on the premises.

“This flies in the face of every auditing principle known to mankind,” said Tim Scala, a former trader who now advises corporations on derivatives trading as president of Treasury Resources Consulting & Investigating. Derivatives are financial instruments such as futures and options whose value is based on the value of an underlying stock, bond, commodity or financial index.

Reports from London and Asia on Tuesday said that Leeson was initially responsible for arbitraging the securities markets in Osaka, Japan and Singapore. By using arbitrage, his job was to spot tiny differences in the price of identical futures trading in both places; by simultaneously buying where the price was lower and selling where it was higher, he captured the difference in price as profit.

But three to four weeks ago, according to Bank of England Gov. Eddie George, Leeson’s strategy shifted. Instead of balancing his holdings of stocks with sales of futures, he began to “go long”--holding growing inventories of stocks and futures in a massive and increasing bet that the Japanese stock market would rise.

Over time he accumulated $7 billion in Japanese stock index futures contracts, George said, as well as a “short” position of $20 billion in Japanese interest rate and currency futures.

The short position was a bet that Japanese rates would rise; although his holdings of interest rate futures were much larger than stock index futures, Leeson lost a greater sum--possibly more than $600 million--on stocks because those contracts are more thinly traded than the interest rate futures and thus subject to more violent price changes.

Both bets were wrong: Tokyo’s Nikkei-225 stock index has dropped from 19,500 in early January to about 17,000 now, and interest rates on the Japanese government’s 10-year bond have fallen in the same period from about 4.8% to 4.45%.

As his wagers went sour, Leeson faced increasing “margin calls.” Because futures and options are “marked to market” every trading day--that is, their values calculated and investors required to cover any losses on the spot--Leeson would have had to put up hundreds of millions in dollars in cash (a margin call) to make good on the deteriorating value of his holdings.

Reports from London indicate that one way he generated cash to cover those calls was by writing options against his portfolio. This means he was selling other investors the right to buy from or sell to himself a specific future or security at a set price at a set point in the future.

In periods of stable markets, the writing of options is a common way for investors to produce more income from their portfolios. When markets move sharply, however, the options writer faces the obligation to cover the commitments he has sold, and his losses can mount.

Among the options Leeson sold, according to some reports, were “straddles” on the Japanese stock market. Straddles are combined options to buy and sell the same underlying commodity at the same price in the same period, and represent a bet that the underlying market will remain flat over the life of the option. If the market moves, as the Nikkei average did in January and February, the straddle turns from a profit producer into a potentially disastrous loser.

Market observers say the most mystifying element of the Barings fiasco is how Leeson was able to accumulate such vast obligations in such a short period. As the Bank of England’s George put it at a news conference Monday, Barings executives “just didn’t know that this chap had taken on these large positions.”

But financial experts say that because futures and options allow investors to take on massive exposures with minimal down payments--in some cases as little as 5% to 15% of the value of the underlying security, index or commodity--traders in those markets must be supervised rigorously and given clear trading limits.

“If the limits are breached, bells go off,” said John Kriz, a managing director at Moody’s Investor Service and an expert in the oversight of derivatives trading. “You set the limits so if they’re breached, you can address the issue before too much damage has been done.”

As it happens, even if Leeson was subject to trading limits, he may have been able to circumvent them through his dual role of chief trader and chief of settlements.

“That meant he was making his own margin calls,” said Leslie Rahl, principal of Capital Market Risk Advisors, a derivatives consultant.

Barings Chairman Peter Baring asserted Monday in an interview with the Financial Times newspaper in London that no institution can adequately guard against determined wrongdoing.

“It’s a cliche in our industry to say we are all vulnerable to fraud,” he said. “It’s extremely difficult to impose control systems . . . (so) people who should have the responsibility to act in a trustworthy fashion should nonetheless have people looking over their shoulders on a minute-by-minute basis to make sure they don’t conceal the evidence of their transactions.”

Rahl argued, however, that losses of this magnitude rarely occur where adequate controls are exercised over traders.

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Times staff writer Charles P. Wallace in Singapore contributed to this report.

* MARKET BEAT

Global investing gone sour? D3

* AFTERMATH OF COLLAPSE

Buyers review Barings as search for trader continues. D6

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Barings’ Collapse: How It Happened

THE GOAL

Nicholas W. Leeson, 28, a trader at the Singapore office of British investment bank Barings, begins amassing huge positions in futures contracts in late January to profit from changes in Japanese stock prices and interest rates.

THE STRATEGY

Leeson buys $7 billion of Nikkei-225 index futures, essentially betting that the Tokyo stock market will rise. He also sells “short” $20 billion of futures tied to Japanese government bonds and foreign currencies, betting that their prices will fall as interest rates rise. Futures contracts enable their holders to speculate on where the stock indexes or bond prices will be at a specified date. If the speculation is wrong, the investor loses.

THE SETBACK

The Nikkei-225 index, which had fallen all year, takes a particularly sharp dive beginning in mid-February. Japanese interest rates also keep dropping, eroding the value of Leeson’s stock and bond futures. But Leeson increases his positions, in an apparent bid to make up his losses in a market recovery, which never comes.

THE COLLAPSE

By Feb. 23, Leeson’s bets are a disaster, primarily his bet on the stock market. With the Nikkei index down 15% in the past two months, his portfolio faces losses approaching $1 billion. Leeson’s position is exposed when he calls Barings for more money. Barings, after sending an investigator to Singapore, realizes it is overwhelmed by the trading losses and files for the British equivalent of bankruptcy. Leeson flees Singapore.

--JAMES F. PELTZ