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TREASURY – Has 7.12%, will swap for 6mth Libor.

Swaps are bilateral private agreements, the details of which are not usually public knowledge. Especially when the deal is innovative, there is no incentive to give the secret away. During nine days in April 1994, three well-known corporations made headlines by announcing big losses from swap agreements. Two features of these announcements turned them into a sensation: first, all three corporations claimed to have been ill-advised and misled by their counter-party to the swap agreements; second, the counter-party in all three cases was the same – Bankers Trust (BT). BT is the money centre bank that transformed itself most radically from a classic bank into an institution driven by trading income rather than the intermediation margin. It made great efforts (see the company’s annual report, 1993) to create an image of a financial advisor and counter-party for state-of-the art financial wizardry. BT was both admired for its innovations and criticised for its aggressive marketing of exotic derivative products to customers. On 12 April Procter & Gamble announced that it had suffered a $157m pre-tax loss on two leveraged swap contracts. A week later, Gibson Greetings announced an additional charge against earnings of $16.7m on top of $3m realised loss on leveraged swaps. The next day, paper manufacturer Mead Corporation announced a loss of $7.4m from debt-hedging operations, including a one-time loss on the close-out of a unique leveraged swap transaction. All three companies filed suits against BT in the courts and with the Securities and Exchange Commission (SEC). The Comptroller of the Currency issued new guidelines for customer protection, and the Financial Accounting Standards Board (FASB) proposed increased corporate disclosure rules. To better understand what happened, it may be best to start with an explanation of a “leveraged swap” and the “closing-out” process. The examples outlined below focus on just one end-user, Gibson, as all cases are very similar. A leveraged swap is an agreement, the returns of which are a multiple of a similar “plain vanilla” swap. On 12 November 1991, Gibson entered into two fixed-for-floating interest rate swaps, each with a notional amount of $30m. Gibson’s target was to lower its interest costs related to a $50m fixed rate borrowing at 9.3% completed in May 1991. First swap: Starting 1 June 1992 until 1 December 1993, Gibson pays fixed 5.91%, while BT pays six-month Libor. Second swap: Starting 1 June 1992 until 1 December 1996, BT pays 7.12%, while Gibson pays six-month Libor. Thus, until the end of 1993, Gibson paid a fixed 5.91% on the first swap and received 7.12% on the second swap thus receiving a net 1.21% per annum for 18 months. (Note that Libor-based payments cancel out.) As the initial value of any swap must be zero, the expected value of the second swap for 1994-96 must have been negative, implying that Libor rates were expected to rise above 7.12%. The goal could have been to shift expected interest rate expenses from the immediate future to the more distant future, or to construct a hedge. Gibson amended these two swap contracts in January 1992 and terminated them in July 1992, receiving a cancellation payment from BT of $260,000. This payment reflected an increase in the value of those swaps to Gibson as interest rates were falling during the first half of 1992. On 1 October 1992, Gibson entered into a “ratio swap”. This is a leveraged swap, which is based on the following formula: net payment = 5.5% – (Libor)2 6% If positive, net payment is made by BT; if negative by Gibson. Under the new swap, the future net payments to Gibson would become negative more rapidly and the difference between the old swaps and the new would become greater as Libor increased. This ratio swap was amended three times to shorten the swap term before being cancelled on 21 April 1993, with BT making a payment to Gibson of $978,000. In one of the amendments, the termination date was shortened in exchange for entering into another, more complicated leveraged swap. Until 4 March 1994 Gibson entered into several additional swaps, all with complex leveraged structures. When, at the beginning of February 1994, interest rates shot up sharply, Gibson had two outstanding swaps with BT and was thereby exposed to interest rate increases. Instead of reducing the cost of its initial fixed-rate borrowing (the initial objective), Gibson added exposure to rising interest rates and got caught. Eventually, BT and Gibson settled their dispute out of court. Instead of paying the full $20m it owed BT, Gibson only had to pay $6.18m. Also of interest, BT made $13m during the last 15 months selling derivatives to Gibson. The Gibson case demonstrates a more general problem: structured deals can have implications that only profound experience and high-powered analytical tools can reveal. The benefit to corporate users can, under these conditions, be substantial. Otherwise, corporations would be better advised to stick to more standard instruments. BT entered into a “Written Agreement” with the New York Fed regarding the future conduct of leveraged derivatives transactions (LDT). This agreement specifies that BT will seek to ensure that counter-parties understand the nature and risk of proposed leveraged swaps. BT also agreed to provide pricing information to counter-parties throughout the life of LDTs. This agreement must be taken by market participants as a signal of Fed policy. The price of leveraged – as compared to plain – derivatives transactions is likely to increase, especially for less sophisticated end-users, to cover more detailed customer information and the costs of potential legal suits. As such, the agreement raises concern about OTC derivatives and may increase the relative attractiveness of exchange-traded products. The Chicago Futures Trading Authority (CFTC) and the SEC imposed a fine of $10m on BT. The CFTC stated that BT had entered into an advisory relationship; the SEC argued that BT knew that Gibson would sustain unrealised losses from tear-ups but failed to disclose that information to Gibson. It also argued that BT caused Gibson to make material misstatements on its financial statements by providing incorrect valuations. By asserting its anti-fraud authority over transactions in this market for the first time, the CFTC has increased the cost of providing advice. Dealers are likely to respond either by maintaining arm’s-length relationships and thus not giving advice to customers, or by charging explicitly for advisory services to cover the legal risk. There are at least three lessons to be derived from the cases involving BT. The first is that OTC products can be complex enough to raise questions about how well understood they are even by experienced corporate treasurers. There is an associated uncertainty about the value of complex products for which there is no market. Dealers are at times tempted to input valuations that make the position look better and customers may find it difficult to evaluate their positions themselves. They become, therefore, unduly dependent on dealers for pricing and management advice. The second lesson is that banks find it difficult to impose a code of behaviour on their staff. Numerous cases, not only these three, but also the Orange County case and many others, show that the incentives for dealers are such as to make them overly aggressive in their marketing. Regulations are unlikely to contain that risk, barring the case where penalties would become so high as to make these products uncompetitive. Third, these cases illustrate actual and potential problems with complicated OTC products and suggest that migration to the organised exchanges is one possible way out. Special Offer Readers of Financial Director may order a copy of Derivatives: The Wild Beast of Finance at £20, a 20% discount off the normal price of £24.95. Please add £2.95 p&p for single-copy orders (p&p free if ordering 2 or more books. This offer may be combined with the management books offer on page 81). Please quote reference KD and ISBN 471.965448. To order, please contact: Cash Sales Department, John Wiley & Sons, 1 Oldlands Way, Bognor Regis, West Sussex PO22 9SA; Tel: (0800) 243407; e-mail: fax: (01243) 843296.

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