In my part of the country, many of the mountain roads do not have safety markings. The U.S. Forest Service mainly uses these roads to maintain firebreak and to insure access in the event fires do break out. The Forest Service employees drive these roads cautiously, well aware of sharp curves, washouts an 500-foot vertical dropoffs. Management doesn't see the need for signs to warn them of hazards or to limit their speed.
It's a little like the market for financial derivatives. As long as you have highly knowledgeable individuals navigating the derivative roadways, you don't need meticulous disclosure to warn about hazards that may lie ahead. However, when the market involves inexperienced and untrained players--the equivalent of tourist drivers on forest roads--you'd better put up warning signs.
Happily, where derivatives are concerned, the regulatory agencies understand that disclosure--warning signs--and accurate internal risk assessments are the keys to heading off accidents involving non-experts. They realize that putting regulatory limits on expert users, like 55 m.p.h. speed limits on wide-open interstate highways, is not the answer.
One can aptly illustrate the point in two recent, highly publicized "accidents" involving derivatives. The first case involves Banc One Corp., something of an expert in using derivatives, the second consumer products giant Procter & Gambl Co.
Taking on AIRS
Starting in 1991, with the help of its investment banker, Banc One began to boo what became a huge position in exotic derivatives known as amortizing interest rate swaps (AIRS). Investors became alarmed over the firm's use of the AIRS early this year, when interest rate pressures began to appear and Banc One's stock price quickly plunged.
AIRS are swaps that amortize much the way that mortgage-backed securities prepay; as with mortgage securities, the AIRS amortize more swiftly when interest rates decline. Banc One's AIRS paid a fixed rate and received short-term LIBOR interest, rendering the firm highly liability-sensitive in a rising-rate environment.
Not that investors clearly understood Banc One's situation. Indeed, the firm's earnings are coming back faster than investors anticipated. In their pessimism, investors overestimated the life of Banc One's derivatives problem.
Ironically, Banc One originally pursued the derivatives transaction as part of plan to strengthen its capital position. In 1989, to reduce its balance sheet leverage, Banc One sold off a large CMO position it inherited in its acquisitio of MCorp in Texas. While the CMO selloff reduced pressures on its balance sheet capital, Banc One knew it also would lose the strong earnings generated by the CMOs.
To recoup earnings lost in the CMO sale, Banc One created an off-balance-sheet synthetic CMO in the guise of the AIRS. The company reasoned that the new product would replicate the prepayment amortization of CMOs while producing eve higher earnings than the CMOs--at least initially.
The AIRS were tailored to re-create the degree of interest rate risk of the CMOs. However, the AIRS reversed the asset-sensitive nature of Banc One's balance sheet, making it vulnerable to rising rates. As LIBOR moved from the 3% range to its present rate, near 5%, Banc One's normally fat net interest margin fell quickly, and investors panicked.
Was Banc One a naive victim of an irrational derivatives market that requires regulatory safeguards to prevent such risk-taking? Hardly. The company is exper at simulating its interest rate exposure and undoubtedly had gauged the downsid of a sustained rise in interest rates. It used derivatives knowledgeably, shifting from an asset-sensitive position, and got caught in a strong interest rate updraft. It was not a hedge. It was a carefully planned interest rate bet that lost.
P&G Meets Bankers Trust
The second "accident" involved Procter & Gamble, a relatively naive player of the derivatives game. In mid-April, P&G announced a $157 million pre-tax loss o closing out swap contracts that went amok when interest rates rose in the U.S. and Germany. P&G's derivatives position was particularly aggressive and speculative because it involved "leverage" that effectively doubled the firm's interest rate bet.
P&G's investment advisor, Bankers Trust New York Corp., structured the transaction in two complex swap agreements that created floating-rate debt for P&G. In addition, however, the transaction called for P&G to sell "put" options to Bankers Trust, giving the bank the right to sell U.S. and German government bonds to P&G in the future at a guaranteed price. P&G was betting that interest rates would fall or at least not change. If the firm was correct, the puts woul expire as worthless and P&G would have doubled its pleasure by simply collectin a handsome kicker for selling the puts.
Unfortunately, U.S. and German rates both moved up decisively in February. P&G' floating-rate interest obligations under the basic swaps began to soar. Simultaneously, bond prices shriveled and P&G was faced with buying bonds from the bank at the above-market prices set by the put option contract, thus leveraging its swap losses. And despite advice to the contrary from the bank, P&G chose to stay with the deal as it continued to pile up losses.
The P&G case exemplifies a trend among some corporate treasuries to play financial markets well beyond the bounds of traditional corporate finance. This traditional finance function is to raise the money needed to fund value-adding investments in real assets and to return funds to shareholders when they cannot be reinvested to achieve added value. To be sure, swaps are a part of this function when they are used to hedge and stabilize corporations' costs of funds But using swaps and exotic derivatives to speculate is another matter.
In effect, despite its skills in traditional corporate finance, P&G's treasury was a tourist on the high-risk derivatives roadway. Bankers Trust, the firm's guide on its derivatives venture, was obligated only to advise P&G of the peril along the route.
Uninformed politicians would require restraints to be placed on the derivatives services offered by sophisticated institutions like Bankers Trust and to increase their liability for professional advice on derivatives. Such restraint would chill a market whose openness and creativity offer significant economic benefits, including the constructive role derivatives play in making the cash markets more effective.
Elaborate safeguards could be constructed to reduce derivatives' risk. Like paving the rutted mountain roads to guarantee the safety of Forest Service employees, however, the safeguards entail unwarranted costs.
