ISF Magazine, June 2004

The industry began the second half of the 1990s reeling from the astonishing revelations of the Barings disaster, and ended with a scramble to cover the losses incurred by Long Term Capital Management. John Piccitto examines how securities finance fought the battle to restore investor confidence.

In between dodging the brickbats, securities finance made considerable progress in the 1990s. It provided more and better services to a widening client base, and improved the policing of its own problems. But regulators struggled to understand and control this growth, and sometimes dropped the ball.

In late February of 1995, London’s top-rated Baring’s Bank revealed trading losses of £825 million. In due course, this venerable institution was placed in administration, and the remaining assets and liabilities of what had been “a viable and prosperous group” were subsequently sold to ING for the princely sum of £1.

What happened? At first, Baring’s London management announced grimly that one of their young Singapore traders, Nick Leeson, had exceeded his authority in unauthorised trading in futures and options. But the amount was staggering: one person had blown more than £800 million pounds of the bank’s money. Leeson fled Singapore, but was finally picked up by police and returned to London, grinning nervously under a back-to-front baseball cap. Then further revelations emerged.

A special house account ‘88888’, hidden in margin files, had concealed Leeson’s unsuccessful activities from auditors and managers. Falsified reports were submitted to London, the profitability of trading was misrepresented and false trading transactions and accounting entries were made. And all this had been going on for four years. Leeson had been sent to the Singapore branch of Baring’s in 1991 to manage the bank’s back office, where he had shown a certain flair for making money. Large bonuses were paid by Leeson’s grateful supervisors in 1993 and promised in 1994. Nobody bothered him as long as the profits rolled in.

A sting in the tail
The Bank of England’s report on the fraud stated that “the system of checks and balances necessary for the proper management and control of a financial institution failed in the case of Baring’s...in a most serious way, at a number of levels and in more than one location...” Some of Leeson’s supervisors were banned from being directors at UK banks, Leeson himself went to jail, and an old and reputable institution joined the decade’s list of bad surprises.

As in the Orange County case, which occurred earlier in the 1990s, an institution bank had failed to supervise and control its own operations and employees. And the public perception of the financial industry was hardly enhanced.

Yet in the Far East, business had burgeoned during the second half of the 1990s. The model of Singapore and the other Asian Tigers – Taiwan, South Korea, Malaysia and Thailand – was compelling. Commentators even wondered if the city state-based economic engine was about to replace the regional economic territories of the last millennia.

For equity finance, it was the Hong Kong Stock Exchange’s executive director, Paul Phenix, who led the way. The objective was to bring onshore a large and growing stock lending business, making Hong Kong a regional hub in this market segment. Changes to the Hong Kong Stamp Duty and to rules on short selling, plus the institution of an AMS trading system, were designed to draw international broker/dealers to Hong Kong. The holding period of loaned securities was extended from 14 days to 12 months; and borrowers of securities were exempted from Stamp Duty as long as they were registered with the Collector of Stamp Duty. As a result, the local market was opened up, because local retail investors could more easily participate in international products like hedging vehicles.

The Hong Kong Addendum, also a result of this push, had to be completed by each borrower and filed in duplicate prior to any business being transacted, along with a certified copy of the OSLA document. But if the Hong Kong Addendum seemed onerous to fill out, it was clearly preferable to earlier proposals requiring borrowers to sign and file individual agreements with lenders, and to file that highly confidential information where it might well be subject to public scrutiny. The compromise was brokered by Phenix.

Exclusives debut
Another great step forward for stock lending occurred in 1995 – the first auction of an exclusive portfolio. In March, Barclays de Zoete Wedd Investment Management (BZWIM) invited broker/dealers across London to bid for portfolios of both European and Far Eastern securities. The beauty parade included a Far East (ex-Japan) portfolio, a Japanese portfolio, a European portfolio and a US equities portfolio. By far the most interesting of these was the Japanese portfolio, but for some reason it was withdrawn from the fray before bids on the remaining portfolios were made, and winners chosen.

But later that year the Japanese portfolio was revived by BZWIM – and it was the now legendary Aquila Japan Index Fund, containing US$1.6 billion in both Nikkei 225 and Second Tier issues. A straightforward calculation (outstanding domestic and international positions less the contents of the portfolio and a bit more for eventualities) produced the winning bid; the lucky winner breaking even on costs after using only 33% of the fund – a goal achieved two months after the fund became available.

Actually getting to the fund itself was not easy – this was everybody’s first time, after all. There were issues about the rate of dividend required for the fund on securities held over record date. Also, in addition to an OSLA Agreement, BZWIM wanted a “Deed Poll” document from the borrower that represented a parent company guarantee (the spectre of Robert Maxwell was specifically raised by the BZWIM’s consultant in this project). And unsurprisingly, the fight for a piece of the pie among the winner’s internal departments (the prime broker unit, the convertible bond desk, as well as the various equity finance trading desks) was protracted and brutal.

The winner of this exclusive had previously borrowed-to-relend in its international operation. Now it had a good supply of stocks to support its burgeoning business in Japan. Also, hedge client inventory was now available for collateral, saving the standard 25 basis point Letter of Credit charges in effect at the time. This alone saved the broker/dealer US$1 million over the year.

The Aquila deal made a lot of money for the lucky winner, so much so that when some of the stocks got really hot, the lender made noises about renegotiating the deal in mid-contract. In the end, what was good about this exclusive portfolio was the impact on the bottom line; whatever the benefits specific to a particular brokerage house, an exclusive portfolio – in the right market, given the right issues – is a very useful business tool. However, exclusive portfolios are only as good as the market in which they trade. For instance, securities being offered to cover tax trading won’t be worth anything if governments then do away with tax trades.

Malaysian meddling
As the business grew in the Far East, some governments made attempts to control it. The Prime Minister of Malaysia became fearful that money was flowing out of the country faster than it was coming in because the country’s stock market was being manipulated by hedge funds and their prime brokers. So the Malaysian government issued an edict toward the end of the third quarter of 1997 which stated that local currency had to remain in Malaysia for a “holding period” of at least one year before it could be taken out, or converted into another currency such as US dollars or Japanese yen.

As a result of this ill-advised dictat, Malaysian ringgit cash positions could not be moved offshore. So cash collateral could not be sent back to its original owners once securities were returned, nor could sale proceeds on the local exchange be converted into sterling or dollars once securities were delivered and money credited to accounts. And sales proceeds resulting from securities transactions had to remain in @ with appropriately situated borrowers took up a great deal of time, for considerable profit.
Unfortunately, by the mid-1990s, governments were beginning to see considerably less money coming into their coffers from dividend tax than they had anticipated. The US banned the practice early on, and the German government made it quite clear that such trading strategies were not acceptable on its patch.

The real demise of the tax trade began in May of 1997, when the Australian government made the shock announcement at a yearly budget presentation that dividend franking credits were to be discontinued, starting immediately. The Australian manager of an international trading desk got over A$700 million in returns that morning, and as day broke around the world, trading desks from Hong Kong to San Francisco frantically returned stock and zeroed out Australian tax trade positions. The Australian tax authorities were making a public stand, and the prospects were not good for one of the most lucrative trading strategies ever employed by hedge funds and broker/dealers alike.

LTCM blows up
In the autumn of 1998, the US Fed Chairman had reassured nervous members of Congress that risk was well under control in the banking and hedge fund industry. One week later, Long Term Capital Management (LTCM), one of the most powerful hedge funds in the world, was declared insolvent by William J McDonough, president of the Federal Reserve Bank of New York.

Within hours of the announcement, a group of 15 American and European institutions were assembled for a bail-out. The group produced $3.5 billion, keeping LTCM afloat in return for a 90% share in the fund’s assets. The fund had been established by John Meriweather, who had gained a reputation as a brilliant trader at Solomon Brothers. Two Nobel Prize winners, Myron Scholes and Robert Merton, had subsequently developed and operated programmes to recognise lucrative spreads. Problems developed when the fund used $2.2 billion from investors to leverage up $125 billion in securities, which in turn became a notional $1.25 trillion in derivative positions.

LTCM bet on the convergence of interest rates. But the Russian rouble collapsed and a global financial shake-out unpredictably widened the spread between interest on US Treasury bills, notes and bonds and the interest paid by other securities. By August of 1998, LTCM was down half its capital, and by the end of September, it needed help in the worst possible way.

McDonough set up a rescue plan to facilitate an orderly market should the LTCM positions have to be unwound. Rather than cashing in huge blocks of securities, small transactions were used to manoeuvre the fund into a semblance of order. McDonough and others stressed that since no public funds were being used, the plan was not a government bail-out.

The New York Times set out in dramatic terms why this was necessary: they had to “prevent a disorderly collapse that could have panicked the credit markets and sent shock waves from small-town real estate offices to the halls of government in Brazil.” Federal Reserve Chairman Alan Greenspan agreed: “Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own...”