Credit Suisse Lost $120 Million in Korean Derivatives Gone Awry By Christine Harper and Jacqueline Simmons Oct. 16 (Bloomberg) -- Credit Suisse Group, Switzerland's second-biggest bank, lost about $120 million on South Korean derivatives in the third quarter, an undisclosed stumble by equity traders struggling to catch the leaders in the securities industry. The debacle, which wasn't reported to shareholders, resulted from the Zurich-based bank's failure to protect itself against swings in the value of Korean stock options, said two people with knowledge of the matter. The loss equals about 13 percent of Credit Suisse's second-quarter revenue from equities trading. Brady Dougan, promoted by Chief Executive Officer Oswald Gruebel in 2004 to run Credit Suisse's investment bank, pledged last year to catch up to competitors in derivatives. The bank's equity-trading revenue rose less than half as fast as Goldman Sachs Group Inc.'s and Morgan Stanley's in the second quarter. Since the blunder in Korea, Dougan has ousted one co-head of equities and overhauled management at the unit. ``They've been underperforming in equities, and if they've made a loss, that could be one last problem that forced them to change management,'' said Andreas Venditti, an analyst at Zurich- based Zuercher Kantonalbank, who has a ``market-weight'' rating on the stock. ``There's not huge confidence in Credit Suisse and its share price.'' Credit Suisse's stock dropped 3.4 percent on Aug. 2 after the company reported second-quarter earnings that were below analysts' estimates, as trading revenue lagged behind Wall Street's five biggest firms. Shares of Credit Suisse rose at an annual rate of 9.5 percent during the past five years, trailing the 14 percent annual advance of the 75-member Bloomberg Europe Banks and Financial Services Index. Korean Market Credit Suisse was drawn to Korea as options trading in the country surged. In the third quarter of 2005, trading of Korean stock-index options rose 71 percent to $12 trillion, surpassing U.S. volumes for the first time, according to a December report from the Bank for International Settlements in Basel, Switzerland. Dougan, 47, a former derivatives trader, declined to comment. Derivatives are financial instruments used to hedge risks or for speculation. They're derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates. Options and futures are the most common types of equity derivatives. Reverse-Convertible Notes Credit Suisse's loss resulted from the sale of reverse- convertible notes, fixed-income securities tied to stock options that are popular in Korea, said the people, who declined to be identified because the trades haven't been disclosed. The returns of such notes are linked to the performance of two or more Korean stocks. So long as both shares stay within a predetermined range, the securities pay buyers a higher yield than most fixed-income investments. If either of the stocks rises above that range, the notes are redeemed with interest. Should one of the shares drop below the range, the bank delivers the stock to the note holder. That gives the bank a so-called put option, which changes in value with the prices of underlying stocks. The faster stock prices change, the more valuable the option becomes. When Korean stocks leveled off in the third quarter after slumping in May and June, option values fell. Credit Suisse, which hadn't taken positions to hedge against the decline in market volatility, was then forced to write down the value of its holdings, the people said. Rating Downgrade Deutsche Bank AG analyst Matt Spick said there is ``a chance of a negative surprise'' from private banking or sales and trading when Credit Suisse reports third-quarter earnings. He cut his investment rating on the company to ``hold'' from ``buy'' on Oct. 12. Spick estimates Credit Suisse's third-quarter net income fell 13 percent to 1.67 billion Swiss francs ($1.31 billion) from a year earlier. The company is scheduled to report its latest financial results on Nov. 2. ``Another disappointing quarter in sales and trading will mean another quarter when the market does not give the company the benefit of its restructuring potential,'' said Kinner Lakhani, a London-based analyst at ABN Amro Holding NV, who recommends clients ``buy'' shares of Credit Suisse. ``They've identified derivatives as one of the areas where they want to boost performance and it's a gap they seem committed to closing.'' French Rivals Korea's structured-notes market grew 50 percent last year to about $15 billion in sales. Credit Suisse competes in it against companies including Paris-based BNP Paribas SA, Citigroup Inc. in New York, Frankfurt's Deutsche Bank and Zurich-based UBS AG, according to research from Arete Consulting, which tracks the market for structured products. ``The history of banks losing money in exotic derivatives is a fairly extensive one,'' said Robert Benson, who ran the structured-products group at HSBC Holdings Plc until he left in 2001 to set up Arete in London. ``At the end of the day, there will be a bust-up or a blowup somewhere. You just hope there are enough other things going right that you can absorb that.'' UBS, Credit Suisse's larger Swiss rival, booked a loss of 919 million francs in 1998 when the company said ``dramatic increases in volatility'' forced it to cut the value of some equity-derivative positions. The bank's statement said the positions included ``illiquid concentrations of market and event risks.'' Toronto-Dominion Bank and France's Credit Industriel & Commercial, or CIC, both incurred losses last year from structured-equity derivatives. `Sweet Spot' CIC, the investment banking arm of Paris-based Credit Mutuel, said in February it had losses of 320 million euros ($400 million) on equity derivatives related contracts in 2005. Toronto-Dominion, Canada's No. 2 bank, recorded about C$164 million ($145 million) of costs to close its structured-products unit outside North America. CEO Edmund Clark said in November that ``the reward for the risk isn't there.'' France's Societe Generale SA and BNP Paribas are the world's leaders in equity derivatives, said Kian Abouhossein, a London- based analyst at JPMorgan Chase & Co. Societe Generale's revenue from equity derivatives will reach $3.6 billion in 2007 and BNP Paribas's will be $2.4 billion, he estimates. Credit Suisse will have $1.1 billion of comparable revenue, he said. Revenue from equity derivatives is increasing at an annual rate of 15 percent, Abouhossein said. ``Equity derivatives are going to be the hottest area, the sweet spot, for investment banking in the next couple of years,'' Abouhossein said. ``On the structured side, roughly 30 percent of revenues a year come from new products.'' Bankers Trust Banks make money on structured products by pricing the securities so that they're selling the embedded options for more than they're worth, as well as by making proprietary trades, said Steve Kohlhagen, 59, a former head of fixed income, derivatives and risk management at Charlotte, North Carolina-based Wachovia Corp., the fourth-biggest U.S. bank. ``A commission on a stock sale is very, very transparent,'' Kohlhagen said. ``The profits on structured products are totally hidden and the securities firms make a lot of money on them.'' Dougan wasn't always behind. He joined Credit Suisse in 1990 as part of a team of derivatives experts from New York-based Bankers Trust Corp., an industry pioneer at the time. Credit Suisse's equity-trading revenue rose 24 percent from 2003 to 2005, compared with 54 percent at Merrill Lynch & Co., 45 percent at Citigroup Inc. and 34 percent at Morgan Stanley. Equity-trading revenue fell 37 percent at New York-based JPMorgan in the same period. Traders Depart Dougan told analysts last year that he planned to build up the derivatives business because ``we still have a gap to competitors.'' Defections may be hampering his efforts. Since the beginning of last year, at least half a dozen executives have left Credit Suisse's equity-derivatives unit. Among them, Nick Nassuphis went to Barclays Capital, Emmanuel Girod and Mike Pringle joined Merrill and Rob Mason left for Morgan Stanley. Credit Suisse's revenue from equity trading rose 63 percent in the first half of this year, trailing gains of 81 percent at Goldman and 73 percent at Merrill. Dougan announced in a Sept. 26 memo that Jim Kreitman, Credit Suisse's 43-year-old co-head of equities, would leave after 14 years at the bank. Tony Ehinger, 48, was handed responsibility for the unit. He also reassigned Chris Carter, who oversaw equity derivatives sales, trading and structuring, replacing him with Simon Yates, 35, the head of convertible trading and derivatives in the Americas. Todd Sandoz, who runs global cash equities trading, was given responsibility for global convertibles and equity risk. When banks lose money in derivatives it's generally because of poor management, wrong bets by traders or unexpected levels of volatility that make hedges less effective than expected, said Kohlhagen, the former Wachovia executive. ``If you're not willing to take that risk, then you shouldn't be in the business,'' he said.
A friend of mine from the industry suggests that most don't make money from trading. Trading is a cost of being in the flow. Some claim they do but it may just be like when you ask a salesman how its going. The banks make their money selling things to their customers not from being clever wolves in the marketplace.