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Dear Lehman: Risk Comes Full Circle

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In 1998, Prof. Succo questioned firm's derivative risk - and was fired for it.

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Editor's Note: The following originally appeared on August 12, 2005 and in light of current events has been reprinted here for the benefit of the Minyanville community.

In 1998, I'd been running derivative trading for Lehman for about 2 years. There, I took the experience I'd first acquired at Morgan Stanley (MS) and applied it by integrating derivative trading with cash (stock) trading. Minyanville's Why Wall Street Will Never Be the Same

We were on the verge of seamlessly combining the 2 in order to make deep liquidity markets in both to customers, while at the same time running large proprietary portfolios. My thesis was that using proprietary positions in derivatives would give us a "basis" for making markets to customers.

We began to dominate the business and attract new customers because of the size of markets we were willing to make. Understand: I do not use the word size glibly; we had intense risk controls, and size in long volatility positions when making markets actually reduced risk.

One of those new customers was LTCM. Through salesmen, they began to do some normal derivative trading, which we were happy to oblige them in. One day, they asked for a market in what was called a "performance swap."

My interest was piqued, because this trade is all about leverage. Essentially, a customer wants price exposure to an asset -- let's say a stock -- but doesn't want to actually buy that stock. There may be some obscure reason why this may be the case, but the real one is that they simply don't want to put up the cash.

In a performance swap, I as the broker would offer the performance of the stock in an over-the-counter agreement, and make the customer put up only a small amount of money in order to honor that agreement (there are details I won't go into here, but they don't change the gist of the story).


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No positions in stocks mentioned.

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