Let's say you and I were planning to see a movie together, and had chosen a financial thriller called "Mismarked" that promised deception, intrigue and betrayal.
We'd buy our popcorn and for the next hour or so we'd cheer as the misunderstood good guys battled the treacherous bad guys. Intuitively, we'd know that the good guys were going to win, but part of the fun would be watching them lose almost every skirmish along the way.
Whatever that version of "Mismarked" might lack in originality, it makes up for by honoring the yearning deep in our hearts for the truth to prevail.
"Mismarked" would also be a good title for the story of the Bank of Montreal's 2007 trading losses, but this story wouldn't make a very good movie. In this version of "Mismarked", despite years of legal wrangling through which the truth was finally revealed and laid bare, the truth was never acknowledged by any of the lawmakers. Instead what we're left with is a hodgepodge of settlements and plea bargains that obscure the truth. The good guys remain misunderstood and the bad guys get to walk away, untouchable.
Do you have a few minutes? If so, allow me to tell you the story of "Mismarked". Listen.
David Lee was a Natural Gas trader for the Bank of Montreal whose book (his portfolio) contained an enormous amount of thinly traded, long dated, out-of-the-money options. (Let's call them "Junk Options") Lee’s high-risk trading wasn’t illegal or even secret yet it doesn't mesh well with the safe and conservative image the Bank of Montreal presents to the public.
The Bank of Montreal skillfully tracked every penny that came in and out of David Lee’s book and the profitability of each trade. They're bankers after all, it's what they do. The Bank’s weak spot was tracking the current value of the junk being held in Lee's book at any given time. The Bank knew exactly how much Lee paid for junk, exactly how much he sold the junk for, and exactly how much he gained or lost on each junk trade. Yet even with all that information, figuring out how much the junk was worth, while Lee was actually holding it, was difficult to calculate and the results were not precise.
(a word about junk options) Options are time-bound investments. If an option can’t be exercised for a profit, it expires and becomes worthless. Short term, in the money options are widely traded, which makes their current value almost as easy to figure out as looking up stock quotes in the newspaper. (It's not quite that easy - but that's the general idea) Long term, out of the money options (junk) are thinly traded, because institutions take steps to limit their exposure to them. The lack of trading activity makes determining the current value of junk options an industry wide challenge. It's not a weakness unique to the Bank of Montreal, nor is it a weakness they're blind to.
The vagueness of junk's value in the hyper-precise banking world can be exploited by traders as a way to even-out minor fluctuations in their books. Exploiting this weakness is a double-edged sword called "mismarking". Banks and institutions, not just the Bank of Montreal, have a way of ignoring mismarking while their traders are up, and then using it as an excuse to fire them when their traders are down. (For a current example of a bank other than the Bank of Montreal doing this, try googling CitiBank's Carl Bonde)
The Bank of Montreal's records estimate that David Lee's book (his portfolio) contained an estimated 7.6 million junk contracts. That's *A LOT* of junk. To put it into context, Warren Buffett is on record as saying that 23 thousand junk contracts is an unmanageable number. (details here - explained in footnote #12) Only the Bank itself knows what percentage of Lee's total book 7.6 million junk contracts represented, but it's safe to speculate that it was a significant amount. The Bank can claim that Lee mismarked the value of the junk options in his book, but they can't deny they had a darn good idea as to the number of them he was holding. The 7.6 million estimate comes from the Bank's own records. That amount of risk in any one book should have been keeping someone at the Bank besides David Lee awake at night.
Here's where Bill Downe enters the story. Bill Downe had only been CEO for a few months when the Bank disclosed David Lee's trading losses. Lee's losses were the result of flawed risk management policies and before becoming CEO, Bill Downe was the person in charge of risk management at the Bank. Critics and investors weren't panicking because they thought Bill Downe was some rookie CEO tasked with cleaning up someone else's mess. No! They were panicking because preventing traders from racking up huge losses had been Bill Downe's one job, he failed, and now he was running the whole bank! Ruh Roh!
The Bank hired a crisis management firm willing to make Lee's trading losses look like the result of a criminal conspiracy rather than the failure of Bill Downe's risk management policies. Please stop reading for a moment and consider that last sentence. That one sentence actually tells you all you really need to know.
Court records show that in order to deflect attention away from Bill Downe, the Bank paid the crisis management firm to meet anonymously with reporters in an off-the-record session. The crisis management team shifted the blame for the trading losses to an alleged conspiracy between David Lee and one of the Bank's vendors called Optionable. Within hours of that meeting, stories appeared in the financial press revealing that Optionable's CEO had a criminal record. The claim was a red herring - it was true, but irrelevant. The red herring scheme worked. The notion that the bank's losses were the result of a conspiracy between a "rogue trader and a criminal" stuck. To this day most accounts of BMO's 2007 trading losses that you're ever likely to find retell the crisis management firm's version of events.
The time has come to say goodbye.
Eight years is a long time to write about one conflict, and it's time for me to accept defeat and step away from the Trader Elvis soapbox.
In an attempt to sum up my experience as Trader Elvis, I'd like to borrow from the fable: The Emperor's New Clothes.
Bill Downe quite naturally fills the role of the Emperor, which allows me to take the role of the naive boy who points out to the horror of the townsfolk that the Emperor is naked. But here's where disappointment sets in. While I think the publicly available evidence clearly shows that the Emperor is naked as a jaybird - that moment of truth when the crowd's denial is suddenly shattered just never happened.
So be it. I'd like to thank everyone who has been willing to talk to me about this case over the years, regardless of which side you're on. I've learned a lot along the way - and there were some areas where I needed quite a bit of patient explanation. Meeting Kevin Cassidy in person in late 2014 was the high point of my time blogging as Trader Elvis. I had to pinch myself several times to make sure I wasn't dreaming while driving Kevin and his lawyer Lawrence R. Gelber to lunch in my beat-up Honda Civic. It was very gracious of them to meet with me and let me know that they've been following this blog all along. (OMG!)
Also - I'd like to make a shout-out to all the other Optionable shareholders who are still holding their shares. I've met a few of you in person and chatted with many others via the Yahoo Finance message board. We may be Krazzzy, but we're not stupid. Not to oversell it, as I'm still a shareholder too, but let's give ourselves credit for identifying what at the time was a great investment. Optionable had an electronic trading platform that was gaining industry acceptance, as well as ownership interest from the NYMEX. None of us could have predicted the impact that the actions of one of their customers would have on the company. In closing, I'd like to thank anyone who has ever taken the time to read this blog for giving our point of view a chance to be heard. Here's to that yearning deep in our hearts for the truth to prevail.
And just like that, they heard a rustling noise..... Trader Elvis has left the building.
Disclosure: I am an investor in Optionable. This blog does not offer advice on buying or selling any security.