Financial Disasters

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lack knowledge of the positions, the temptation exists for traders to exploit the control weakness to run inflated positions. This action often leads
to another motivation spurring the growth of risky positionsthe Ponzi
scheme, as discussed in Section 2.2.
Some traders who take risky positions that are unauthorized but disguised by a control weakness will make profits on these positions. These
positions are then possibly closed down without anyone being the wiser.
However, some unauthorized positions will lead to losses, and traders will
be strongly tempted to take on even larger, riskier positions in an attempt
to cover up unauthorized losses. This is where the Ponzi scheme comes in. I
think it helps to explain how losses from unauthorized positions can grow
to be so overwhelmingly large. Stigum (1989) quotes an astute trader with
regard to the losses in the Chase/Drysdale financial disaster: I find it puzzling that Drysdale could lose so much so fast. If you charged me to lose
onefourth of a billion, I think it would be hard to do; I would probably end
up making money some of the time because I would buy something going
down and it would go up. They must have been extraordinarily good at losing money. I would suggest that the reason traders whose positions are unauthorized can be so extraordinarily good at losing money is that normal
constraints that force them to justify positions to outsiders are lacking and
small unauthorized losses already put them at risk of their jobs and reputations. With no significant downside left, truly reckless positions are undertaken in an attempt to make enough money to cover the previous losses.
This is closely related to doubleornothing betting strategies, which can
start with very small stakes and quickly mushroom to extraordinary levels
in an effort to get back to even.
This snowballing pattern can be seen in many financial disasters.
Nick Leesons losses on behalf of Barings were just $21 million in 1993,
$185 million in 1994, and $619 million in just the first two months of 1995
(Chew 1996, Table 10.2). John Rusnaks unauthorized trading at Allied Irish
Bank (AIB) accumulated losses of $90 million in its first five years through
1999, $210 million in 2000, and $374 million in 2001 (Ludwig 2002, Section H). Joseph Jetts phantom trades at Kidder Peabody started off small
and ended with booked trades in excess of the quantity of all bonds the U.S.
Treasury had issued.
The key to preventing financial disasters based on misrepresented positions is therefore the ability to spot unauthorized position taking in a timely
enough fashion to prevent this explosive growth in position size. The lessons
we can learn from these cases primarily center on why it took so long for
knowledge of the misreported positions to spread from an insider group
to the firms management. We will examine each case by providing a brief
summary of how the unauthorized position arose, how it failed to come