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Managing Risks in Financial Markets

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Case Study: Sumitomo

Managing Risks in Financial markets

Saad Group, Al-Khobar, Saudi Arabia

July 2006

Managing Risks in Financial markets

Case Study: Sumitomo

July 2006 1

Analyzing Sumitomo

I received my first lessons in commodity trading from my father when I was still a teenager, well preceeding

my years at Cargill. My father had the unfortunate privilege of taking delivery of a carload of eggs because he

owned the nearby egg futures. On that occasion be said to me, 'Marl, always be careful trading in the nearby

contract, you may have to eat it for breakfast. " Some market participants could use my fatber's good advice.

Today, we will look at a case that contains this mistake, the case of Mr. Hamanaka at Sumitomo.

The obvious problems

Whether you are a trading partner, the trading management, lender, regulator, market facilitator, reporter, or

casual observer, the methodology for analysing a trading problem should be the same. You must expand the

problem beyond the obvious to uncover hidden sources and new problems when the instinct is to do the

opposite in an attempt to minimize the problem's impact. This expansion process will prevent the two common

mistakes made in these situations. The first is denial that various problems exist because these problems may

reflect poorly on you or your organization. The second is hindsight bias or reorienting the facts to support your

story. By avoiding these pitfalls, Sumitomo and the industry as a whole can make changes and emerge

stronger.

The first step in the process is to ask, "What are the obvious problems?" These have been widely reported in

the press and we will review them briefly. But even before we list these obvious problems, we need to make

sure we all understand the case facts. From the hundreds of bits of reported information, there are ten relevant

topics.

The important things to know

1. The world copper market is relatively small and Hamanaka was called Mr. 5% in recognition of his market

dominance. He was known to trade off the market; selling below the market, buying above it, and selling

large quantities of over the counter options cheaply. The prime motivation for trading away from the

market is to move prices, called painting the tape by traders. The prime reason people sell cheap options

is to create current income to cover bad price trading.

2. Hamanaka is a lawyer. He is smart, he worked long hours and often late at Sumitomo, he turned down

transfers, and he was highly regarded, even winning the President's award. We can therefore assume that

he knew what he was doing, and that he was working late for some reason other than being promoted to

new positions.

3. Hamanaka granted power of attorney over Sumitomo trading accounts to brokers and effectively lent

Sumitomo's debt capacity to third parties. These actions are highly unusual.

4. Hamanaka's pattern of trade became increasingly complex, increasingly large and less transparent. This

process accelerated after 1993 though the use of futures, options and swaps. All of these can provide a

source of leverage.

5. Hamanaka's volume of trade was primarily through relatively small and newly formed brokerage firms with

offshore locations. He represented a large portion of their business and the firms were extremely

profitable.

6. Hamanaka was financing his positions through large credit lines and prepayment swaps with major banks.

He created a source of liquidity through swaps that could be off balance sheet.

7. Hamanaka is reported to have had the authority to create brokerage accounts, bank accounts, execute

loan documents, and authorize cash payments. Normally these require multiple signatures. Traders are

never permitted to authorize cash payments.

8. Mr. Hamanaka was transferred to new duties on May 17 while Sumitomo still had a large exposure to

copper prices. Prices fell 30% after the reassignment. Hamanaka confessed on June 5 and Sumitomo

unwound some positions in the following days. He was fired June 13 and Sumitomo announced a loss of

$1.8 billion that they say occurred over ten years.

9. Seven people in connection with the case have been fired, demoted, suspended or resigned for personal

reasons. These were either in Sumitomo or in brokerage companies

10. Hamanaka is known to have made only one trip since June 5. This was to London.

Managing Risks in Financial markets

Case Study: Sumitomo

July 2006 2

How to lose $1.8 billion

The first eight items in the list are clues that a problem was likely to occur. Many items on the list are classic

signs of a trader operating out of bounds and should have been seen by the people involved at the time. The

last two items point in the I I I direction

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