Friday, May 04, 2007

New Management at BMO's NY Commodity Trading Desk

The Globe and Mail, Sinclair Stewart & Tara Perkins, 4 May 2007

Bank of Montreal is reshuffling oversight of its commodity trading desk in New York barely a week after announcing it would have to take a $350-million to $450-million charge because of its commodity trading.

As of this week, the commodity team will report into the financial products group, headed by Patrick Cronin and Mark Caplan, according to people familiar with the matter.

A BMO source confirmed the change yesterday, saying it was one of the actions it has undertaken to deal with the costly trading incident.

Sources said the supervisory change had been contemplated for months, but was put on hold indefinitely while the bank figured out the extent of the accounting charge it would have to swallow.

They added it makes sense to move responsibility for commodities from the fixed income group to financial products.

"The decision was to put it under one operating group," said one banking official. "At the end of the day, you want to have proprietary trading report to one entity."

Mr. Cronin and Mr. Caplan have experience in equity derivatives and interest rate derivatives, respectively.

Chief executive officer Bill Downe said last week that the bank was conducting a thorough review of the situation and actions had been taken to address it and reduce the likelihood of a recurrence.
Financial Post, Duncan Mavin, 3 May 2007

When David Lee was betting Bank of Montreal's money on New York's risky natural-gas markets, rivals eyed their trading screens nervously.

"There's not many guys who would trade against him ... usually it took at least three guys," said an energy trader at a big New York City financial institution.

Mr. Lee is the man at the centre of BMO's $450-million losses revealed last week by Bill Downe, BMO chief executive.

A New Jersey boy from a bluecollar Italian family, Mr. Lee has worked his way up the ranks of BMO's commodity-trading desk during the past eight years. Bonding over beers with other natural-gas traders and brokers, he learned the ropes and his reputation grew, and so did his trading book, according to numerous sources, including colleagues, rival traders and brokers, who spoke to the Financial Post on condition of anonymity.

In the past couple of years, the down-to-earth family guy -- now in his late thirties, married, with two children and still living in New Jersey -- has made hundreds of millions of dollars for BMO.

The brokers, hungry for a share of his trade, came to Mr. Lee, schmoozing BMO's star trader over dinner and at Bruce Springsteen rock concerts.

"He is up there in the options world," said a rival options trader. "He is such a large trader and he trades so frequently that you pay attention to what he's doing."

But now the man who dominated the natural-gas options market is nowhere to be found.

BMO employees at his workplace forward all calls to the public relations office in Toronto. A private line to Mr. Lee has been disconnected. And commodity traders in New York say Mr. Lee and BMO's executive managing director of commodity products Bob Moore, were conspicuous by their absence from the markets yesterday.

It is believed that Mr. Lee and Mr. Moore are being held responsible for the bank's trading losses and will lose their jobs over it.

"Someone has to take the fall for it," said an energy-options trader. "There has to be accountability."

BMO has not confirmed the two men will be terminated. The bank said last week that nobody had been fired.

Insiders say the two men are only being kept around to help unwind the loss-making positions to prevent further damage.

Since BMO's announcement on Friday, U.S. brokerage house Optionable Inc. has seen its stock slide more than 30%. Optionable receives more than a quarter of its revenue from BMO's natural-gas options desk. It is believed Mr. Lee placed a high proportion of his trades with Optionable and had a strong relationship with the company's chief executive, Kevin Cassidy.

BMO's Mr. Downe said last week that the bank will "reposition [the natural-gas option] portfolio to a lower and sustainable level."

However, Mr. Cassidy said BMO remains a client of Optionable. Meanwhile, Optionable's chairman and founding partner Mark Nordlicht resigned on Tuesday.

Mr. Nordlicht said his resignation was not connected to BMO's losses.

BMO has blamed the losses on market conditions that combined to move against the bank's trading positions, as well as a refinement in the method used to value the trading book. But a number of analysts and energy industry observers have questioned whether the bank's risk management procedures were to blame for not uncovering the losses.
Financial Post, John Greenwood, 3 May 2007

Stephen Schork is a high-profile energy analyst and editor of the Schork Report, an industry newsletter. A former floor trader at the New York Mercantile Exchange, Mr. Schork has spent much of his career following the twists and turns of the global natural gas market, where Bank of Montreal recently lost as much as $450-million. Mr. Schork, who is based in Philadelphia, spoke with Financial Post reporter John Greenwood earlier this week.

Q Were you surprised to hear the Bank of Montreal report that it could lose as much as $450-million from trading natural gas?

A Over the past few months two hedge funds, Amaranth and MotherRock, and now BMO have reported huge losses. A few years ago [what happened to BMO] would have been huge, but now these outliers are becoming the norm. BMO was one of the first big banks that I'm aware of to get into energy trading, along with Bank of America four or five years ago. In the early 1990s when the power markets deregulated, you saw Wall Street coming to the utilities and telling them they got this large physical asset and that they should trade around it and leverage it. Companies like Enron took this to the max and built up real large energy trading shops. After Enron collapsed there was this huge void in the market because they had left. But then you began to see Wall Street come back. You saw firms like Goldman Sachs and Morgan Stanley and they were taking big positions. Suddenly the market shifted from Houston up to Wall Street and then from Wall Street to Connecticut where all these hedge funds are located.

BMO is a very sharp, sophisticated trading house but they got themselves into trouble because they were trading at a time when liquidity was being pulled out of the market.

What happened to them is called a roach motel, meaning they have taken up these positions that were easy to get into but with the lack of liquidity, there was no way for them to exit their positions.

Q Why did the liquidity dry up for BMO?

A Because of Amaranth. When Amaranth collapsed in September, they left the market. And when a large well-capitalized fund like that blows up, risk managers at all the other players, at the banks and the financial institutions, they want a thorough investigation of what's going on in their own shop. Now that BMO has pulled back you're going to see liquidity dry up again as people pull back.

Q What's next for BMO? What hope do they have of containing their losses?

A They are at the point now where they have lost so much money that they are reporting it. But the fact that they are not giving a definite number is a little scary for them because it's telling the market that they've still got this position on. Once the sharks smell the blood in the water, they are going to want to extract as much meat off the bone as they can. So if it is true that BMO is not out of their position in the market, they stand to lose even more than they have said.

Q Who are the sharks in this case?

A What tends to happen is that commodity trading is a zero-sum gain. In other words, for every dollar that's lost, a dollar has been gained. What ever BMO lost, there is someone standing on the other side of those trades who is $350-million to $450-million richer. This is the environment of energy trading. So the guys on the other side of BMO's trades could be anybody, hedge funds, utilities, a financial institution.

Natural gas is today what the dot coms were in the late 1990s. It's literally grown into a casino now, and it's become a wag-thedog scenario.

If you think about it, a derivative is something that's supposed to derive its value from a physical asset, but now you don't know if the derivative market is driving the physical market or the other way round.

Q This sounds like a dangerous place to be. Was what happened to BMO just bad luck?

A I don't think Amaranth was bad luck and I wouldn't characterize BMO that way. But this is why you have risk managers. All trading is about trying to make an educated guess with incomplete information. Where BMO might have fallen down is with their risk model. There are a lot of questions around the reliability [of such risk models]. A lot of them don't [recognize] your worst-case scenarios.
Financial Post, Duncan Mavin, 2 May 2007

Bank of Montreal plans to terminate two executives involved in the bank's $450-million natural- gas options trading debacle, say sources close to the bank.

David Lee, who manages the bank's book of natural-gas options, and Bob Moore, BMO's executive managing director of commodity products, are being kept around by BMO only while the bank attempts to unwind its trading positions without incurring further losses, the sources say.

Both men work for BMO in New York.

A BMO spokesman said he could not confirm or deny that the executives would lose their positions with the bank.

BMO sent an e-mail to the Financial Post yesterday saying it takes the trading losses "extremely seriously."

"We are conducting a thorough review, and that is ongoing. When it's appropriate to do so, we will comment further. I also want to reiterate that actions have been taken to address the current situation," the e-mail said.

BMO chief Bill Downe announced the trading losses last week, saying they were caused by the markets moving against the bank's energy trading desk.

The bank said historically low levels of volatility in natural gas prices had led to a drying up of demand for natural gas options, leaving the bank holding lossmaking positions. The bank also blamed the losses on a "refinement" in the way it valued the trading book.

Mr. Downe said the change in the market occurred in the past eight weeks.But many banking and energy trading insiders have questioned the bank's explanation for the losses. Sources close to the trades in question say the losses were the result of Mr. Lee placing bad bets on natural gas prices, which were probably not discovered for several months because his trading portfolio was valued inaccurately.

Banks and other businesses that trade in commodities usually use a model to value their book of trades.

"They are basically saying that the model is off all this time and they misstated numbers. That is a serious thing," said an executive with a U.S.-based natural gas option brokerage.

"Nobody loses $450-million in a quarter," he said. "It is a crazy market [but] you die a very slow death when it goes against you. That's the type of loss that could happen over a year."

Mr. Lee is one of the biggest traders of natural gas options in the market. Much of his trade has been conducted through brokerage firm Optionable Inc, whose stock has declined 24% since news of BMO's trading losses first emerged. BMO is directly responsible for a quarter of Optionable's revenue.

Yesterday, Optionable said its earnings for the second quarter of 2007 increased more than 300% from US$2-million last year to US$9-million.
The Globe and Mail, Rob Carrick, 2 May 2007

In the banking sector, one person’s scandal is another’s buying opportunity.
We’re talking here about Bank of Montreal, of course. The bank shocked investors at the end of April by announcing that botched trading of natural gas derivatives will cost it between $350-million and $450-million on a pre-tax basis, or between 45 and 55 cents per share. BMO shares closed at $71.27 the day before the news broke, and then edged down to the low $68 range over the next three days. This isn’t a huge decline, but it should be enough to draw the attention of investors interested in acquiring shares of a big Canadian bank at marked down prices.

BMO is the worst-performer among the Big Six banks over the past three years, so there was already a case to be made for looking at it. Now, it’s an even better bargain, especially for investors seeking income. If you’re looking at a blue-chip replacement for BCE shares, take note.

At $68.50, BMO shares yield 3.97 per cent. That’s the highest yield in the past seven years, and also the highest among the banks listed on the Toronto Stock Exchange. Even unloved Laurentian Bank has a lower yield – 3.61 per cent. BMO’s yield looks even better when you consider that the bank has a history of raising its dividend by a compound average annual 12.5 per cent over the previous 10 years. Over that same period, the shares have risen almost as much. The message to take away from this data is that BMO shares have a degree of built-in support thanks to a dividend that has steadily risen over the years.

The big banks have a solid history of being good purchases when they’ve taken a hit. Canadian Imperial Bank of Commerce shares took a couple of big hits in 2005-06 as a result of its efforts to extricate itself from its role in Enron’s collapse, and now CIBC shares are the second-best performer among the major banks over the past 12 years with an increase of almost 20 per cent. The top performer in the past 12 months? Royal Bank of Canada, which had a turn in the doghouse a few years ago because of troubles in its U.S. operations.

Lagging bank shares don’t turn around on a dime, but there are powerful forces at work to help them along. One is their rock-solid dividend, while another is the public embarrassment that comes with announcements like the one BMO was forced to make in regard to its natural gas trading activities. The big banks are proud organizations and setbacks like these often seem to drive much improved results going forward. There are no guarantees, of course, but buying a big bank when it’s on a down swing has in the past been a smart value play.