What I Learned from Losing $200 Million

It was 2008, after the Lehman Brothers bankruptcy. Markets were in turmoil. Banks were failing left and right. I worked at a major investment bank, and while I didn’t think the disastrous deal I’d done would cause its collapse, my losses were quickly decimating its commodities profits for the year…

…after a black cab ride from Heathrow to our Canary Wharf office, I got the guys off the trading floor and into a windowless conference room and confessed: I’d tried everything, but the deal was still hemorrhaging cash. Even worse, it was sprouting new and thorny risks outside my area of expertise. In any case, the world was changing so quickly that my area of expertise was fast becoming obsolete.

The 2008 financial crisis taught me about the illusion of control, and how to give it up.

In mid-2008, as crude oil prices were soaring to nearly $150 per barrel, the government of Mexico (the world’s sixth largest oil exporter), in an attempt to hedge a fall in oil prices, bought insurance in the form of put options. The options gave Mexico the right (but not the obligation) to sell oil at $70/barrel. If the price were to fall below $70, Mexico could exercise the options to receive a higher price on the oil than what it was selling for in the market. They paid $1.5 billion to hedge 330 million barrels of oil (100% of net exports for 2009).

The oil price fell to around $33/barrel by the end of the year.

The seller of the options (aka the option writer – Bob Henderson, on behalf of an unnamed bank) was effectively guaranteeing that Mexico would receive no less than $70/barrel for the oil no matter how low the price fell. To do so, he takes the other side of the trade.

The problem? There was no market for Maya crude on which the option could be structured, so he had to improvise using a standard derivative technique – he created a proxy for Maya via a “basket” composed of (roughly) West Texas Intermediate (the global benchmark for oil) and fuel oil. As the oil price fell, he needed to keep the option price steady (technical term: delta hedging) so he could pay Mexico if they exercised the option. How did he do it, as the value of the crude oil portion of the basket was plummeting? By selling fuel oil. How much did he need to sell? Enough to move markets.

There were many other decisions and guesses, some made alone, others with help from my team, and still others made by my boss. All were guesswork, none could I have anticipated in stress testing, and all involved abandoning my original strategy along with the illusion of control it gave me.

The Financial Times on Mexico’s oil hedge before and after.

Press Release (Mexico): Federal Government 2009 Oil Hedge Results

Futures & Options World Awards

Black-Scholes: The mathematical equation that caused the banks to crash