As Derivatives Debacles Add Up, It’s Time to Ask: Hedge or Risk?
Between Kidder Peabody’s shocking $350-million loss in phantom bond trades and Procter & Gamble’s embarrassing $157-million pretax rinsing courtesy of a failed “hedge,” cynical investors might be forgiven for wanting to go short on the future of futures, options and other such financial derivatives.
Public advocates--perennially fearful that derivatives might fuel a financial meltdown--clamor for increased regulatory oversight, while the Securities and Exchange Commission pores over public filings to see if companies adequately describe their exposure with these instruments.
Instead of being seen as dynamic, innovative tools to better manage risk, derivatives are portrayed as far too complex, too volatile, too risky--and the people who trade them too greedy--to be a cost-effective instrument for conservative financiers. Just as after the 1987 stock market crash, derivatives today are being demonized as deadly viruses of speculation.
The reaction by the derivatives world to this rising portfolio of debacles is hardly a self-consciously mumbled “There but for the grace of God go I.” Instead, there is an angry contempt for the way their global, multibillion-dollar marketplace is now being defined by aberrant behaviors.
“These things blacken the entire market,” says one derivatives specialist at an international investment bank, “when in reality, this is really one of the best and most open markets in the world today.”
In the case of Kidder Peabody’s Nietzsche-reading government bond trader Joseph Jett, derivatives traders are simply “incredulous” that a scam half the size of the firm’s capital base didn’t trigger a sophisticated management review.
“These were not odd-lot trades,” a former Salomon Bros. managing director says of Jett’s alleged $900-million-plus market manipulations. “I cannot understand how this goes on for more than a year without someone asking this guy into their office to walk the trades through and explain how he’s managing to trade so successfully for so long. It’s just not comprehensible.”
As for Procter & Gamble, was the global consumer products giant really trying to use derivatives to better hedge its currency and interest rate exposures in its multinational markets? Or was the maker of Ivory and Tide as interested in profitably speculating in derivatives as investing in detergents? (The company itself claims its money-losing swaps went against its investment policy.)
The instruments “were so insanely geared that they had to be taking a bet,” says Susan Webber, a management consultant who advises derivatives firms. Other derivatives players agree: “It’s very difficult to design a straightforward hedge that performs so poorly,” says one Goldman Sachs derivatives designer. “We’re not that clever and we’re not that stupid. What P&G; bought wasn’t just a hedge.”
The real issue surrounding derivatives today isn’t their sophistication and complexity; it’s the openness and honesty of the institutions that trade them. The truth is that it’s easy to lie with derivatives. So some people do. Complexity isn’t a reason; it’s an excuse.
“Derivatives are so fungible and versatile that you can take a variety of derivatives and make something that is very convoluted but that also does what you want,” acknowledges a former Bankers Trust derivatives specialist now at a global investment bank. “If your intention is to disguise and deceive, you can do that.”
For example, it’s not uncommon for aggressive global corporations and their equally aggressive corporate treasurers trying to hedge their operations in Europe to want to “capture some of the upside” if the deutsche mark should go down against the dollar. At what point does sweetening a hedge turn it into outright speculation? Because the tax treatment of corporate hedging and corporate financial speculation is substantially different, the answer to that question is worth millions of dollars. Sometimes hundreds of millions.
Now, suppose the company has built into its business plan that German interest rates will rise but that the Japanese yen and the dollar will hold strong. Is the hedge designed around these assumptions an example of financial speculation? Or a responsible effort to hedge the organization against its legitimate business expectations?
These questions are almost impossible to answer. But what makes this situation intolerably worse--and what leads to such unpleasant surprises as multimillion-dollar write-downs by such seemingly well-managed firms as Gibson Greetings and Procter & Gamble--is the fact that these companies are not required to disclose their hedging strategies to the public markets.
In other words, investors have no real way of knowing whether a $500-million basket of currency options and futures held by a Fortune 500 company represents a prudent hedge or a speculative bet.
“More needs to be done in the area of disclosure and accounting,” says SEC Commissioner J. Carter Beese. “Significant interpretive guidance will be forthcoming from the SEC. Shareholders have the right to know what their exposures are before they wake up and read it in their newspaper.”
The greatest risk derivatives bring to the marketplace is not their complexity or volatility; it’s the shadowy way in which they can be used by companies that would rather not tell the marketplace the truth about their investment intentions. The antiseptic for that infection is not more regulation; it’s better and fuller disclosure.
