CASE STUDIES ON FINANCIAL ENGINEERING -Bankers Trust, Sachsen Landesbank, Orange County

The building blocks for financial engineering are forwards, futures, swaps, options, and securitized products. By using these tools, a risk manager could hedge either a granular risk exposure or a basket of risk exposures
Risk managers need to be careful about which goal a hedging strategy is pursuing. In its purest sense, a hedging strategy can be used for risk mitigation. Alternatively, some firms have used hedging strategies to enhance returns. This second strategy usually adds more layers of risk rather than mitigating current exposures.

In the early 1990s, Proctor & Gamble (P&G) approached BT to help manage interest rate risk in both U.S. dollars and deutsche marks (the German currency at the time).
After discussion with Bankers Trust, P&G decided to bet on an interest rate decline using complex leveraged swaps
At one point, it was leveraged 20:1 in a series of swaps where BT would pay P&G a fixed rate in return for a floating-rate payment from P&G
Federal Reserve began to raise interest rates (by 250 basis points) in 1994.
This unexpected change cost P&G a substantial sum of money, in part, because it chose to be speculators and not just hedge risk exposures. Its leverage amplified the losses.
P&G ultimately sued BT and won a judgment of $78 million. Several other firms had a similar experience with Bankers Trust and the resulting reputational damage was too much to overcome. BT was eventually acquired by Deutsche Bank.

In the early 1990s, California’s Orange County treasurer, Robert Citron, used short-term repos to borrow an additional $12.9 billion. Citron subsequently invested all assets and all borrowed funds into complex inverse floating-rate notes.
These securities have coupon rates that decline when interest rates rise.
Orange County was completely reliant on lenders being willing to roll forward the repo contracts when they matured (i.e., a maturing repo was replaced with a new repo contract rather than paid for with cash). Initially, this strategy allowed Citron to earn 2% higher than his peers.
However, when the Federal Reserve raised interest rates by 250 basis points in 1994, Orange County’s strategy fell apart when coupon rates dropped on the complex derivatives and investors did not roll forward Orange County’s repo products.
This ultimately resulted in a bankruptcy filing. Citron later admitted that he really did not understand the risk exposures of inverse floaters

In the mid-2000s, the Landesbanks saw the profit potential in the U.S. subprime lending market. They began to establish off-balance sheet entities in other countries that could hold securitized subprime mortgage loans. Sachsen Landesbank was one such bank
It created an off-balance sheet entity domiciled in Dublin, Ireland, and bought a large amount of subprime assets. When the financial crisis of 2007-2009 struck, Sachsen sustained such heavy losses that it had to sell itself to another German bank that had not pursued the alluring profits of securitized subprime mortgage products.

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