We are recognizing our obligation for accounting purposes; however, it is clear that the company should never have been put in a position like this as we relied on Bankers Trust to advise us on these transactions. We have taken measures to ensure this will not happen again.”
These are the words of Benjamin J. Sottile, chairman, president and CEO of Cincinnati, Ohio-based Gibson Greetings Inc. the third largest greetings card manufacturer in the US, after the firm discovered that it had made $20 million (Rs81 crore) losses for the quarter ended March 1994 on interest rate derivatives transactions with Bankers Trust.
William L. Flaherty, Gibson’s chief financial officer, clarified that the loss was recognized for accounting purposes at the current market value of the derivatives transactions, as determined by a Bankers Trust valuation model, based on the projected future value of the transactions at maturity.
Hundreds of small, medium and large firms in India now face a similar situation. Accounting norms are not clear, yet, on whether they would need to provide for the losses on the basis of current market value of their derivatives transactions but the fact is, with the greenback depreciating fast against some global currencies such as Japanese yen and euro, their losses are mounting.
In April 1994, Gibson announced the loss on an interest rate swap with Bankers Trust. Under the arrangement, that covered a notional amount of $30 million, Gibson was to benefit if the interest rates dropped, but if the interest rates rose, Bankers Trust would make large profits and Gibson large losses. Gibson made profits initially but later, it was saddled with losses. For financial sector observers in the US, this did not come as a shock. As early as in January 1992, Gerald Corrigan, a former US Federal Reserve official and chairman of the Basel committee on banking supervision, in a speech delivered at New York State Bankers Association, warned of the danger of derivatives transactions. Susan Philips, another Fed member, too, had warned the US Congress of the risks from OTC (over the counter) derivatives.
Not too many people paid attention to such warnings till Gibson announced its derivatives loss. Procter and Gamble Co. followed Gibson and announced huge losses before filing a complaint against Bankers Trust, claiming a loss of more than $100 million due to alleged fraud. The government of Orange County, California, declared bankruptcy after losing $2 billion in speculative transactions. It had invested its entire tax collection in structured notes and “exotic” instruments. Its elected treasurer Robert Citron, who was heading Orange County’s trading desk, was dealing with several brokerages, including Merrill Lynch and Co. Other municipalities and educational institutions also lost hugely in derivatives trading in mid-1990s when structured instruments such as death-backed bonds, worthless warrants, heaven and hell bonds, exploding options, sushis, downunders and kiwis flooded the US market. The profit-to-loss ratios enjoyed by the derivatives dealers in the US in early 1990 were 2,000:1 but that dramatically changed after the Gibson disclosure.
In India, the first time media reported derivatives loss of a firm was in 2006 when the Food Corporation of India suffered a loss in its swap transaction with a British bank. Being a state-run firm, it did not hide its losses, but hundreds of small and medium firms that bought such products from banks in the past few years are not talking about their transactions till such time the potential loss is enough to wipe out their entire net worth. And the losses are increasing even as the blame game continues. Lawyers and risk management experts?who are?being?hired by the firms?that have burnt?their fingers are accusing banks?of “mis-selling” and enticing firms to?“speculate”?instead?of hand-holding?them to genuine hedging while banks are calling these lawyers “ambulance chasers”—a derogatory phrase that typically refers to attorneys who solicit business from accident victims or their families.
Union finance minister P. Chidambaram had last week made a statement in Parliament, saying banks operating in India had Rs127.86 trillion of derivatives on their books as on 31 December 2007. The “outstanding notional principal amount” of derivatives, according to him, was 291% higher than the corresponding number on 31 December 2005.
By itself, the amount is not meaningful as it is the notional amount of all derivatives transacted such as rupee derivativ-es such as OIS (overnight indexed swap) or dollar rupee forwards. This number also includes two legs of transactions which could actually be reversing or closing out any risk that a bank has. Typical products that have been permitted by the Reserve Bank of India (RBI) are forwards, currency swaps,?interest rate swaps and?foreign currency options.
Banks in India carry a market risk on their forex contracts but this is largely controlled by the net open position limit that?RBI?prescribes?for?each?bank.?The?larger?risk?that?the?banks carry is the credit risk. Since they are not allowed to keep a cross-currency book, they always need to enter into a mirror contract with an overseas bank when they sell cross-currency options to their customers. So, a customer can back out but a bank cannot from the second leg of the contract. Here lies the main problem. And legal suits are no solution to this.
As Indian corporations increasingly become international, derivatives will indeed become an entrenched risk-management tool across various exposures such as interest rates, currencies and commodities. But they must understand the instruments and the risk well before taking the plunge. Greed will punish both banks and firms equally.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to email@example.com