Derivatives Can Be Hazardous to Your Health: The Case of Metallgesellschaft FraNkUN R. Enwarns FRAriuan R, EDwane i the Aor F. Buns profesor im dhe Graduate School of Business 2¢ Columbia University, and ite Ing scholar at the American, Emtepaive hice it Wainy ‘on, DC Late 1993 and early 1994, MG Refining and Marketing, Inc. (MGRM), the American affli~ ate of Germany's fourteenth largest industrial firm, Metallgesellschaft AG (MG), reported staggering losses of about $1.3 billion on positions in energy futures and swaps (see Protzman [1994] and Eckhardt and Knipp (1994]}. Subsequent to these losses, MG spent another $1 billion buying its way ‘out of contracts it had made with Castle Energy.’ Only 4 massive $1.9 billion rescue operation by 150 German and international banks kept MG from going into bankruptcy, an event that would undoubtedly have had far-reaching consequences for MG's creditors, suppliers, and some 58,000 of ies employees (see Miller (1994)). Had MG defaulted ‘on its enormous derivatives positions and other debt obligations, major international banks and perhaps ‘even the clearing association of a major farures ‘exchange could have sustained substantia loses, the ramifications of which we will never know. ‘What went wrong at MG, and what can we learn fom the MG experience about the pitfalls of| ‘sing derivatives? How could large, sophisticated, worldwide enerey conglomerate like MC have been 0 inept as to incur derivatives-related losses that all bbut destroyed the firm? Clearly, derivatives can be hazardous to a firm’ health. WAS MGRM HEDGING OR SPECULATING? Initial prece reports of MGRM’s losses suggested that MGRM incurred these losses as a 8 Darevarrves CaN BE HAZARDOUS TO YOUR HEALTE Tit CASE cP METALLGSELLSCHAFT ‘Son 1995result of massive speculative positions in energy Bacures and over-the-counter (OTC) energy # During the latter half of 1993, MGRM purportedly established long energy futures and swap positions equivalent 10 neatly 160 million barrels of oil, post- tions that would benefic handsomely if energy prices rose. Instead, energy prices (crude oi, heating oil, and gasoline) fell sharply during the latter part of 1993, causing MGRM to incur huge unrealized losses and margin calls on its derivatives positions. Subsequent press reports, however, sugzest that MGRM was not speculating but was in fact using derivatives 10 reduce the exposure it had to rising energy prices. In particult, MGRM was said to be engaged in a complex hedging operation using both futures and swap contracts as a hedge against a lage volume of fixed-price, forward supply contracts for gasoline and heating oil that it had written for customers MGRMS forward supply contracts commit- ted it to supplying at fixed prices some 160 million barrels of energy products over the next ten years to end-users of gasoline and heating oil. The fixed supply prices were agreed to when the contracts were entered into, and were typically $3 x $5 a barrel higher than the prevailing spot prices at the ime the concracts were negotiated (this was MGRM% profit margin or markup). Most of these contracts were negotiated during the summer of 1993, when energy prices were falling and end-users saw an attractive opportunity co lock in low energy prices for che focare, MGRM’ counterparties in these forward contracts consisted of retail gssoline suppliers, large ‘manufacturing firms, and even government entities Although many of che endousers were eal firme some were substantial: Chrysler Corporation, Brown= ing-Fernis Industries Corporation, and Comear Indus ‘ies, which has annual diesel fuel use of some 60 million gallons a year (sce “New Shadows.” 1994) These forward supply contracts exposed MGRM to rising eneray prices. If energy prices were to rise in the future, MGRM could find itelf in the unprofitable postion of heving to supply energy prod Luce to its Customers at prices below prevailing spot prices. If prices rose high enough, MGRMS profit margin could be eroded, and it could even have ended up with substantial loses for years to come. Thus, MGRM reportedly sought to hedge is price risk with long futures and OTC saps ‘ot co have hedged this risk would have pur MGRM (and therefore MG) in the position of Sieve 1995 making a substantial bet that energy prices either ‘would fill of at least not rite in the Future, a bet too large for MG to have prudently made. MGRM'S HEDGING STRATEGY MGRM sought to hedge the risk of rising energy prices by acquiring long energy fatures posi- tions on the New York Mercantile Exchange (NYMEX) and by entering into OTC energy swap agreements to receive floating and pay fixed energy prices (see Taylor and Bacon [1994)). MGRMS swap counterparties were large OTC swap dealers such as major banks. During the latter part of 1993, MGRM held long furures positions on the NYMEX ‘equivalent of 55 million barrels of gasoline and heat- ing oil (55,000 futures contract), and had swap posi tions amounting to some 100 to 110 million barrels, substantial poriciont by any mescure (ee Taylor and Sullivan [1994)). Thus, MGRM was hedging its forward supply contracts on a one-to-one basis with energy derivatives. ‘An important aspect of MGRM’s hedging strategy is chat its derivatives positions were concen- trated (or stacked”) in short-dated futures and swaps that had to be rolled forward continuously to main- tain the hedge.? In general, MGRMS futures and swap positions were in contracts with maturities of at most a few months fiom the current date, so that it had to roll these contracts forward periodically (perhaps even monthly) to maintain its hedge against the forward supply wontza.s, This short-dated stack hedging strategy clear- ly exposed MGRM to the basis risk associated with its having co roll its furures and swap positions Forveird through rime MGR M apparently believed this risk to be acceptable Indeed, MGRM believed that a short-dated stack hedging strategy was the most attractive hedg~ ing strategy for ewo reasons (see Benson v. MG (1994). Fist, because its forward delivery contracts included an “early liguidation”” option for end-users af energy prices were co rise, MGRM believed that the actual duration of itt forward supply contracts ‘would likely be far shorter than the periods stated in ‘he contracts jee Falloon (1994). If end-users were to exercise their options, presumably because the options had value to chem, MGRM would have (© make substancal up-front, lump sum payments £0 chem at the time of exercise, These lump sum payments would be based on changes in spot (or neat-month) energy prices. Dasovarves Quasrenty 9Specifically, they would be based on the difference between the prevailing near-month {atures price at the ume of exercise and the conteac- tually fixed supply price times the quantity t0 be supplied over the term of the contract, MGRM believed that 2 stack hedge, which would increase in value substantially as spor and near-term energy prices rose, could be relied on to provide the needed funds for MGRM to meet these potential carly- payment obligations Second, MGRM saw the necessity of having to roll its positions forward constantly as a benefit and not as a rik, MGRM believed ie could extn a positive returns by rolling its positions forward, More specifically, its rolling-forward strategy was designed to take advantage of a common characteristic of nergy futures markets: backwardation le backwardation markets, oil for immediate delivery (neaeby-oil) gets > higher pries than does deferred-delivery oil, such as thtee-month oil. Thus, a sttategy of purchasing deferred-delivery contracts and continually rolling these postions forward yields profit (or “roll gains”) MGRM strategy, therefore, sought to exploit the backwardation that 1s common in energy farures markets, Its implicit assumption was that enerzy futures markets would continue being in backwarda- tion much of che ume, and that the roll gains it made when markets were in backwardation would ‘more than offiet any rol loses that it incurred when markets were in contango." While itis clear that under certain conditions 4 shore-dated stack hedging strategy such as MGRM. Used can be an effective way to hedge long-dated forward commitments, there are sill risks associated with it} Fits, as with any hedging strategy, there is, “operational” risk. Hedge postions must be correct ly implemenced and managed (and in particular che “hedge tatio™ muse be correct) for the hedge to reduce price exposure effectively Second, there is “basis risk” associated with I hedging strategies. MGRM's hedging strategy exposed it to “intertemporal basis risk” because it requited MGRM to roll its derivatives positions vonstantly forward through time.” Under cera conditions, rolling positions forward can result in substantial losses. Third. MGRM was potentially subject to a fionding risk” because its derivatives positions were subject to mark-to-matker valuation and to varia~ tion margin payments, while its forward supply ccongracts were not. Under some circumstances, this 10. Dekivarves CaN Be Hazanocus 0 YOUR HEAL Th Cast oF MeTALLCELASCArT marking-to-market asymmetry could result in MGRM needing sizable amounts of funding to cee margin calls Fourth, MGRM$ forward supply contracts exposed it o “ctedit risk” MGRM‘ ability to profie on its forward supply contracts depended on its customers honoring theit contractual obligations to purchase oil for many years into the future. Finally, MGRM was subject to “reporting risks." As we shall see, the application of inappropri- ate accounting and disclosure conventions to MGRMS hedging acuvities resulted in misleading financial statements that threatened to undermine public confidence in the firm.7 WHAT WENT WRONG? MGRMS problems surfaced in late 1993 when energy spot prices tumbled (instead of rising, as MGRM had both expected and feared). As a result, MGRM experienced large unrealized losses on its stacked long futures and swap positions and incurred huge margin calls" Adhering to German accounting and disclosure principles, MG disclosed these unrealized loses publicly, sending shock waves through the financial community Tn addition, because of an unusual forward Pricing curve in energy fuiures suutkers during 1993, MGRM sustained substantial “rolling losses” when it rolled its large stacked futures positions forward ‘through time. In 1993, energy fatures markets were in contange for almost the entire year, causing MGRM to incur losses each time it rolled its deriva- tives postions forward If, instead, energy prices had risen rather than fallen, there would have been no problem. MGRM. would have had unrealized gains on its derivatives positions and positive margin Oows (or cash indlows) In addition, when prices are rising, energy markets are often in backwardation, rather than contango, so that MGRM may not have had roliover losses, The fact that MGRM also would have had uncealized loses on its forward delivery obligations would not hhave mattered, No one would have cared. Duc eneigy prices did fll, om around $19 = barrel of crude oil in June of 1993 to less than $15 2 barrel in December 1993, forcing MGRM to come up with enormous amounts of money to fund margin calls and rollover losses so that its hedge posi- tions could be maintained. In response to these reversals, MG's supervisory board brought in new management, which quickly made the decision co Seren 1995‘iquidace the bulk of MGRM% derivatives positions and forward supply contracts. ‘While complete information about all aspects of MGRMS energy and hedging strategies is noc yee available, some key implications can already be drawn from the MG experience, First, conflicting and inappropriate accounting and disclosure conven- tions can undermine a firm’s hedging strategy by causing confusion among its creditors and investors about what the firm is doing and about its financial Position. Confusion of just this kind undermined public confidence in MG, likely weakening its ability Co cope with MGRMS problems Second, short-term funding requirements such as MG experienced, ifnot anticipated and prop- erly managed, can undermine an otherwise sound hedging strategy: Finally, lack of understanding at board level about how 2 firm is using derivatives can ‘limacely undermine a firm's hedging strategy, CONFLICTING AND MISLEADING ACCOUNTING CONVENTIONS MGRM‘s problems were compounded by widespread confusion about ies financial position caused by conflicting and inappropriate accounting conventinne Under German accounting, principles, tunrealized fasses on open forward positions have 10 bbe recognized at the end of the financial year, but unrealized gains on open forward positions are not allowed to be recognized.” For MGRM, this meant that, when energy prices fell in late 1993, MG had to recognize MGRMS unrealized losses on its derivatives po toons (futures and swaps), but was unable to recog- nize any unrealized gains that MGRM may have had con its forward supply contracts. Thus, MG reported huge serivativerselated losses, leaving the impres- sion that these losses were incurred by inappropriate and possibly speculative trading in deewatves by MGRM, and chat MG’ financial solvency was itself in jeopardy. Not recognizing the gains on MGRM's forward supply contracts resulting from the fall in eneray prices distorted the teue picture of MGRMs financial position. Falling energy prices made MGRM's forward supply contracts more valuable, Because thewe contracts gave MGRM the right tn cll cil at higher fixed prices. Ic is hypothetically possible that MGRM's unrealized derivatives losses comld have been almost entitely offet by unrealized gains oon i forward supply contracts." Sees 1985 (Even if “perfectly” hedged, MGRM. would will have experienced lorees because of its rolling costs during 1993, However, these losses would have bbeen much lower than the losses on the derivatives positions that occurred because of falling energy prices during 1993) In any case, MGRM would certainly have had some amount of unrealized gains on its forward supply contracts, which would have offtet some of its derivatives losses. Thus, had MGRMS unrealized gains om its forward supply contracts been recognized a well as the unrealized losses om its derivatives posi- tions, MGRM {and therefore MG) would have been. able to repore smaller losses than it did, Unlike German accounting conventions, US. hedge accounting principles recognize this reporting asymmetry, and impose different disclosure require- ments on hedgers. US. “hedge-deferral” accounting principies do not require that either unrealized gains oF unrealized losses on hedged postions be recognized. Thus, had MGRM been subject to USS. accounting principles, it would not have had to report its unrealized derivacives losses at all. fe would not have had to report these losses until realized, which would presumably have occurred at the time that it also recognized the gains on its forward cpply coments Alternatively, U.S, accounting conventions allow a firm with a hedged position to mark both sides (or positions) to market. In particular, MGRM_ ‘ould have marked to. market both its forward supply contracts and its derivatives postions, permitting che immediate recognition of the respective gains and losses on both positions. The application of both German and US. accounting principles to MGRM clearly crested confusion among MG's creditors and investors. In particular, MG's US. and German auditors at different times isued conflicting repors on MG's condition. (On November 19, 199, just before ns super visory board meeting at which MG's then-Chair- man’s conteact was extended for another five years. MG's US. auditor, Arthur Andersen, disclosed that MGRM had a $61 million profit before taxes for the fiscal year ending September 30, 1993. Further, it reported that MGRMS US. parent, MG Corpora tion, had a profit of $30 million for the fiscal vear (Gre Eckharde and Knipp (1994) Just a short time later, however, M| German auditor, KPMG, apparently applying German accounting principles, reported a loss of hundreds of millions of dollars for MG's US. opera Denwareves Quagrenytions for the same fiscal year ending September 30, 1993 (see “Benson's Billion Dollar Lawsuit” (1994). Which set of figures gave the most accurate picture of MG's financial health? One indicates that MG was profitable and doing nicely, che other that MG's losses were so large that they threatened the solvency of the firm. Thus, conflicting and inappropriate accounting conventions contributed to confusion about MG's crue financial state, undoubtedly weakening the firm’s ability to deal with its problems FUNDING PROBLEMS Because of falling energy prices, MG was forced to fund sizable margin calls on MGRM's derivatives positions. According to press reports, MG's creditors balked at providing the necessary funds for MGRM ww meet dhese margin calls (se Parkes and Waller (1993). Ie is not clear, however, why MG’ creditors refused to make this credit avail- able. If, for example, MGRM had unrealized gains ‘on its forward supply contracts (due to falling energy prices) that were equal and offetting to the unreal- ined losses on its derivatives positions, itis not clear why MGS creditors would have refused to make loans against the collateral of these forward supply contracts. The market value of the firm, afterall, would not change, MG creditors may have been reluctant to lend against the collateral of MGRM's forward supply concracte far two reasons. First, these contracts may have lacked sufficient transparency. In particular, cIchough falling energy prices, everything else equal, should have increased the net present value Of MGHUMs forward supply contracts, MGS creditors may have been concerned about the continued creditworthiness of MGRM’s contractual counterparties over the Jong time period covered by hese contracts (x much 35 ten years). For MGRM {0 realize is fell profits on these contracts, its coun- terparties would have to make good on their fucure obligations to purchase oil fom MGRM at the fixed contractual prices, which mighe have been consid ably higher than prevailing spot prices at che cime of the required purchases. Thus, if MG's creditors believed that they did not have sutficient information to make an indepen- dent evaluaon of MGRMS credic risk, they may have responded by heavily discounting the potential increase in. MGRLM’s cash flows on its forward supply contacts, This would have made it dificult for MG 12. Deswanves Cat Be HAZAROOUS T0 YOUR HEALTIE Tit CASE oF METALLSESLLCCHATT either to sell (or liquidate) ts forward supply contracts fo to borrow against them to meet margin cals Notwithstanding this possible non-trans- parency, it has been reported that on December 7, 1993, Chemical Bank (and possibly other banks) offered financing to MGRM on the basis of MGRM_ securitizing its forward supply contracts (see Eckhardt and Knipp (1994)). Of coune, we do not ‘know the terms thatthe banks were offering, or how big the “haircut” would have been. In addition, it is noteworthy that MG had available a DM 1,5 billion Eorocredit line with forty-eight banks that it seem- ingly could have used to fund margin calls The second reason that MG's creditors may have refused to make the necessary finds availabe is that MGRM muy have been “overhedged” MGRM has reported using a one-to-one hedge ratio, which. may have resulted in its derivatives position being ‘greater than required to match (or to offer) changes, in the net present value of its forward supply contracts due to price changes. Ifthis were the case, when energy prices fell, MGRM would have incurred greater losses on its long derivatives poi- tions than it would have had gains on its forward supply contracts. ‘Thus, the value of MGRM’ forward supply contracts would not have been sufficient to collater- slize the loans it needed, forcing MG to borrow by increasing its general debt obligations. The prospect of such a large increase in MG's debt may have alarmed its creditors, especially when MG's conflice- ing financial disclosures about MGRMS activities created an atmosphere ot uncertainty and confusion. about the continued viability ofthe firm, MG's funding needs also were aggravated by actions caken by the New York Mercantile Exchange (NYMEX) at the end of December 1993, Just when, MGRM’s funding needs were the greatest, NYMEX demanded “supermargin” — margin in excess of owice notmal levels — fom MGRM, placing sn even greater stain on MGS resources. NYMEX also revoked MGRM’s “hedger exemption” from its speculative position limits, forcing MGRM to liqui- date part of its fituree positions and to realize some of ts unrealized losses (See Culp and Hanke (1994). Te is not clear why the NYMEX took these drastic “regulatory” actions, but it appears to have acted only after the December 17 fring of the entire management board of MG by MG's supervisory board. Also, the new management’ decision to force MGs commercial counterparties to draw down on. the standby letters of credit issued to MG by various Sra 1995banks may have convinced the NYMEX that MG was eaugh in a liquidity squeeze Thos, in retrospect, it is clear that MGRM's hedging strategy did expose it to “funding” risk asso- ciated with having to meet margin calls on is shore= dated derivatives postions, and that MGRM was not adequately prepared to meet these funding needs Further, MGRM' funding problems appear to have been exacerbated by conflicting and misleading accounting and disclosure conventions and by a lack of understanding on the part of its creditors and the nancial community about exactly what it was doing, LACK OF UNDERSTANDING AT ‘THe SureRvisory Boano Lever On November 19, 1993, the supervisory board of Metalgesellschaft extended the contract of its management board chairman, Heinz Schimmel busch, for another five years, Exactly four weeks later, the same supervisory board fired Schimmel- busch. MG's new management quickly decided to liguidite the bulk of both MGRMS derivatives posi- tions and its forward supply contracts, a strategy that proved immensely costly for MG. Between December 20 and December 31, 1993, when prices for crude oil, heating oil, and gaso- line were at their lowest in many years, MGRM liqui- dated most of MGRMS futures and swap positions, resuling in substantial realized losses on its derivatives positions." Judging from daily closing prices for that period, MGRM paubslly liquidated diese punisivnn at an average price of about $14 a barrel.!? Assuming that MGRM had acquired these derivatives positions at an average price of $18 a barrel, an average liquida- tion price of $14 4 harrel wmuld have meant a lot of ‘$640 million on its 160 million barrel derivatives posi- tion"? In addition, in order to eliminate is exposure ‘on its forward supply contracts if prices rose, MGRM. liquidated these contracs as well, apparently waiving, cancellation penalties on the contracts, thereby giving vp unrealized gains that could have offer atleast some of MGRM's derivatives loses Had MG’ new management not ordered the Liquidation of MGRAMS position, the situation would be far different today. From December 17, 1993, ‘when the new management took control, to, August 8, 1994, crude oil prices increased from $13.91 to $19.42 a barrel; heating oil prices increased from $18.51 to $20.94 a barrel; and gasoline prices increased from $16.88 to $24.54 a barrel.'* Given, these price increases, MGRM would have had Senase 1995 substantial unrealized gains in its derivatives positions anda hngp inflow of margin funds, ‘What inferences can be drawn from MG's supervisory board’s decision to liquidate MGRM's forward supply contracts and its derivatives positions? ‘We know that during the summer of 1993, when ‘energy prices decreased sharply, MGRM substantial ly expanded its strategy of providing its customers with fixed-price, long-term, forward supply contracts, and then hedging its price risk with deriv atives, Thus, prior to its extending Schimmelbusch’s contract on Novernber 19, MG's supervisory board ‘must have known (or, if it did not, it should have known) about MG’: forward-contracting strategy and its use of derivatives The supervisory board’s liquidation decision in December, therefore, suggests three interpreta tions. One is that the board was informed about MG's forward contracting strtegy but did not fully understand the potential risks and funding require- ments that the strategy entailed, Another is that che board understood the risks that were involved, but liter changed its collective mind about the magnitude of these risks in the face of the huge margin cals that ‘occurred. Stil another possibilty is chat the strategy that the board approved was sound, but the board panicked in the face of huge margin cals when it ‘ordered the liquidation of MGRMS positions. Under all three scenarios, one thing seems ‘leat: At some point MG’ supervisory board either failed to understand fully MGRM forward-contract- ing and associated hedging strategies or seriously misjudged the risks that MGRMS strategy entailed. > WHAT ARE THE LESSONS FROM MFTATILGFSFITSCHAFT? Metallgesellschafi’s near-collapse and experi- ence with derivatives suggests some lessons for firms using derivatives and for policymakers. My infer- ences can be drawn fiom the MG experience inde- pendent of what one might conclude about whether MG's strategy exposed it co unreasonable risk. ACCOUNTING AND DISCLOSURE CoNvENTIONs Must BE APPROPRIATE Conflicting and inappropriate accounting and disclosure conventions can creat: uncertainty about & firm’ hedging program and make it dificult for a frm. to raise money when it needs to. Accounting and disclosure requirements for firms using derivatives to Dunwvarives Quaseteny 13hedge cat be informative if they are appropriate, and provide mean inirmation. Crbersvse, they ean result ‘in misleading tinancial statements chat ean wreak fuvoe on Bats and snashets. Paticulaily is tapidly develop ing markets like OTC derivatives, accounting and disclosure conventions developed to meet past needs ‘may be inappropriate for eporting new activites Ihe MG case clearly demonstrates the dangers of treating derivatives positions differently om the assets or lisbilisies that the derivatives are being used 10 hedge. There should not be accounting recognition of gains and losses on derivatives positions used for hedging unless che gains and losses on che positions that are being hedged also are recognized. MG's disclosures recognized losses on its derivatives positions but did not recognize any gains con the forward energy contracts it Was hedging Thus, aucounting anu disclospse conventiva chat treat derivatives positions asymmetrically are misleading and can result ip unwarranted market responses to firms’ disclosures ‘Two aceounting alternatives seem preferable to the one used by MG. One isto matk both sides to market — the derivatives postions and the positions being hedged. The other is to adopt "hedge-deferal” principles." The first, marking both positions to ‘market, requires an ability to determine reasonably accurate and unambiguous values for all positions. fn Some cates, thie may he dificnlr and may give the firm wide lstitude in determining values. MG may be 2 case in point. MGRM*: forward supply energy contracts were for durations 5 Jong as ten years. To deteruiine the ace present value of these contracts, therefore, it would be necessary to select a forward pricing curve for the various energy products on which the forward contracts were writen No choice is clearly correct. and any choice could subject MG to cfiticism, since MG would be able co exercise considerable discre tion in making its choice For instance, MG could have chosen to value the conaraces on the assumption that current spot ener ay prices would exist for the next ten years, Alterna ‘ively. it could have used the forward pricing curve that exixced ac che time of i report ~ but reliable forward prices for energy products are available for only a shore period of cime into the future. MG would have had to select s methodology for exmepolating oxzing forward prices out to ten years, Shus, whatever method MG sed to estimate the present valve of ts forward supply contracts could subject i 1 ert, 14. Densvarives Cus Be HAzAnooUS to YOUR HEALTH: Tite Cas OF METAUCESELLSCIAFT ‘The valuation of MGRM% forward supply contracts was made even more difficult by the pret- ence of two additional factors: The contracts includ- ed “carly liquidation” cunvanee optiuns, and there was considerable uncertainty about MGRM's coun- ‘erparty credit risk. “Wich respect to is customer options, if ener~ &y Prices were to mise such that MGRMS forward supply contracts went “into the money” for its customers, MGRMS customers had an option to “cash out” of these contracts, requiring MGRM to make subseantal up-front payments, Further, the exercise of these options would substantially shorten the duration of the forward supply conteacs. Thus, (0 value the forward supply contract, ic would have been necessary to estimate the likeli- hood of the embedded options being exercised (which was dependent on the likelihood of an increase in energy prices aud on changes ia che forward pricing curve), and the likely costs co MGRM if the options were exercised. Considerable discretion exists in che procedures that MGRM could have used to value these options. Finally, che options were asymmetrical. MG’ customers had no option in the event of falling enes- ay prices (wich is what aceually occurred). The value of MGRM’s forward supply contracts was also dependent on how the credit rise associated with these contracts was evaluated. Although these contacts would hecome mane valli able to MGRM if energy prices fel, MGRUMs abili- ty €0 resp the full value of these contracts was dependent on the willingness and ability of its cuxoniets (© meet their contractual obligations over 2 period of time at long as ten years. To value the forward supply contracts, therfore, it would be necesiary £0 estimate probable default rates over many years and to place a concrete number on the likely diseibucion of MGRM's defaule losses."? Once again, MGRM would have had considerable discre- tion in how it determined its likely defile losses. ‘The second alternative accounting conven- tion is the “hedge-deferral” principle, under which neither gains nor losses on derivatives positions used for hedging are recognized until the gains and losses on the positions being hedged are realized. While this procedure has the virtue of treating both sides symmetrically, it may not provide adequate disclo sre of the risks that rms aze taking, In particular, application of hedge-deferral accounting principles to MGRMs hedging strategy ‘would nor have made clear the risks that this strategy Senne 195entails. Ic would not, for example, have made clear the implications of MGRM not having a hedge position that balanced changes in the net present value ofits forward supply contracts, of the implica- tions of its using short-dated derivatives to hedge long-term commitments ‘At minimum, therefore, adoption of hedge deferral accounting conventions should be accompa nied by foomotes explaining the nature and purpose of the firm's derivatives positions and the pocentia risks to which the fre is exposed.!? There remains, of course, the issue of how complete 2 frm disclo- sures ean be before they become unacceptable because they require revealing proprietary information. BOARDS AND MANAGERS ‘Must UNDERSTAND DERIVATIVES, ‘STRATEGIES AND IMPLICATIONS {cis eriical that both senior managers and the board of directors of a frm understand how a firm is ting derivatives, an, if che firm is using derivatives as part of a hedging wrategy, chat they understand and approve of the potential ramifications and risks associated with this stategy. In general, the board should formally raufy this stategy before tis imple- mented.*" In addition, senior managers should understand the firm’ exposure to changes in prices and to acs changes, and should be informed about potential funding needs, The facts of the MG cave suggest that MOS supervisory board either did nox fully understand che risks associated with MGRM‘s forward-conteacting and associated hedging strategy or did not correctly evaluate these nsks when i approved this strategy. BOARDS AND MANAGERS MusT ACKNOWLEDGE FINANCIAL AND REGULATORY CONSTRAINTS Jt is important for hedgers to anticipate and to manage funding needs. 4 eriical need isto have ‘he backing of financtal instutions that understand and approwr of the fir’s te af derivatives, and are willing to advance credie to fund margin oudlows on derivatives positions. MG apparently did not have such an understanding with its creditor banks, Managers of firms using complex derivative strategies must be cagnizane of the possibility of unanticipated “regulatory” actions (by either government regulators or exchange officials), and of the potential consequences of these actions for the Sera 1905 firm’s position. The actions taken by NYMEX in raising MGRM’ margins and revoking its hedger cemption cleatiy exacerbated MG's problems. DERIVATIVE Maaxer Liquiosty The MG case suggests that both organized futures markets and OTC derivatives markets may be ‘more liquid than commonly believed (see, for exam- ple “Financial Derivatives..." [1994]). The forced liquidation of MGRMS massive derivatives positions was accomplished quickly, with very litle marker impact. Almost all of this liquidation was done, either directly or indirectly, on the NYMEX. MGRM sold its long futures positions directly, and, in liquidating its swap positions, ic undoubtedly forced its swap counterparties (or dealers) to liqui- date the long fotures positions on NYMEX that they were almost surcly using to hedge theic swap pos tions with MGRM., During MGRIM’s mastive liqui- dation late in December 1993, energy prices were largely unchanged, and even rose a bit. Apparently, theer were ample buyers readily avaiable to. absorh MGRMS forced sales INTERNATIONAL CONSIDERATIONS ‘The MG debacle raises an obvious question about the efficacy of the German system of corporate governance. This system relies on large stakeholders ina company acting as directors and managers of the company. As I have argued elsewhere, in theory directors with a large stake in a company’s perfor- mance will be better informed about the company’s activities and can be expected to be more vigilant monitors of the company’s management. (See Edwards (1993] and Roc (1993) MG is @ classic example of a German fri: Seven institutional investors held just over 65% of the companys stock, The Emir of Kuwait held 20%, Dresdner Bank, Germany's second-largest commer cial bank, held 12.6%: a holding company jointly owned by Deutsche Bank (Germany's largest commercia} bank) and Allianz (a major insurance company) held 13.2%, Daimler-Benz, the giant automaker, held 10%; the Australian Mutual Provi- dent Society held 69%; and M.1M. Holdings Ltd. of Australia held 3.5% (see Proteman [1994] and “Metallgesellschaft Woes..." [1994)). In addition, German banks typically control large amounts of stock through proxies given co them by theie cliens The chairman of MG's supervisory board is Ronaldo Desavarives Quasreniy 15Schmitz, who also is a prominent member of the management board of Deutsche Bank. Despite this high-powered board, a lack of understanding at the supervisory board level appears co have contributed substantially to the MG debacle. ‘The MG experience, therefore, cleatly brings into question the etiectiveness of the German system of corporate governance and, in particular, of large banks as corporate monitors. Recent press articles have indicated that lead- tng poli in all parties in Germany have inero- duced legislation ¢o limit the stakes that banks can hhold in industrial companies. (See Friedman (1994].) ENDNOTES [An eattr version of ths arile wat presented atthe Conference on "The Implicsions of Derivatives for Regulion,” {don School af Economie December 2 1986. The author thanks conference paracpen for ee helpful commen "see "How a Former Banker.” (1994), MG's sot lowe pps 10 be almost as ch 15H emie toa capil, which wat ‘DMS.579 om Speer 30, 1984 See Afidave of W. Arthur Benson, W Anh Been Malpelo 1 Th Tusek” ledge refers to 4 acures postion being "tacked" or concenated i 4 parle delivery menth or mort rather than being opread over many delivery months In MGRM's case, ¢puced the ente 160 millon bare hedge in shor-dated Salvery month, rather than spreading thot amount over many, longersired,dlvery month ‘Cornman revon fo xing then-daed ack hege ae shat ligidny i nach beer in nea-month contr (or Tongerdatee esivaves ate sonply noe avadale), and hedgers may bold eerie fexpecisons about how the term aroctue of energy fates prices vel change inthe frre. Culp and Miler (1994 refer to MGRMs ‘honda, such hedging toy etek” repr “Marken which newoy pce are Blow defred-month ries are commonly efered to 0 “contango” marke fn conange mae, MGRM's roll forward smtegy woe produce lose. Stora deruton af the pot and cont af wack hedging rte, see Edwards snd Mi [1992 p. 308-007. Fora dacesion of tsing 4 shore-dced wack hedging strategy +o hedge long-ted Ford eblgison ee Colp and Miler [1934 *MGRM may ao have been exposed to significant bese raf “exoarhedsed” — hedged, ay, heabag ol wih crude oi facures. The fll den bout MGRMs hedgng orion have not do fh "edwards and Carer (1995) analy dese ek in grees eu. "russes contrac act marked to mathe diy by exchanges ad trader are required t post with the exchange any Loe they incur ta a2amon, wile swap conti usualy 36 908 tory Imad to minke, su ot uncomnmen for counterpart tsp 2greemens 9 cal for seinonal cote fam louingcounterpiiet 2 loses moure Such cose en een be poem the frm oF bak lee of ee "One reson fr these account principles may be sh Germany fans atemens ace wed for a purpose at wel Th, ifthe objecaive & ta: masimize “tax lees” ecogning only nel feed ees accomplhes hs "eth would have been we, for example, iF MGRM had 16 Denvarnves Cas Be Hazanoous 70 Your HEALTH THE CASE OF METALICESEUSCHAPE sce ted» minmumevaance hedge so "MIRC 01 Dison Reais ax 3 coil, and gascline. q “hg i ot Sh gang is pout ual seine coy in 94 "aime Rgsidion begin whe the new management took congsh an December 17. 1003 See MRG Olt Dios ‘Revie Fax 193], “CEO Schimmel Leave MC" 193), nd°MG fr Top Manageme Ae La [99 USthe fet shar MG's spereory boul ia December sre shemaciveaeon tht cult hve reed Maat fener margn ofr i evidence tha i ids beet tat MGRM freeing seme) wo icaenay sna Fat crams, MG could have presed sol pu frher Marge orflown dv top decry pushing pt opi om encgy frotare, whch were sale Deventer 1998 Tis ouesy Sold tive neeriaed fer margin Sutows on MERA ong ‘area np pont. ny ve bene skin he et purmonn mee "see "Recommadon 19 Accouing Ps” of the emi iy Sey 9 whch ae — End-uien sould secoun for derisive wed to ‘manage risks 10 8 to achieve a consistency of tncome recognition eatmentGetween thee ia ‘mene and he st being managed. Thus, the ek Deing managed accounted for at cost (ot, i the ‘se of an anipstry hedge, not yee recogrined), changer inthe valve of + gualifving sak managee ‘mene instrument should be defened unl» gin ot loa is recognised om the rok being mamgeds Or iF the ek being managed is asked to market with change in rive taken to income, a quaifvng rk ‘management ineroment should be treated in 3 — Enduoner should account for derivatives not qualifying for risk management scestment on + trar-tovmaes ba there evidence that “cumulative” defi sharply with dine, Se Fos (1994) ‘iser “Recommendition 10: Mestuning Creit Expat.” in the Group of Thy Seudy [1993], wach prope het ender snd dees mene credit exposure in 0 wa: = Curent expose, which the relcemens cot of denen ramsactions, tht, thew mathe vale — Pozen exponte, which an exami of the fare replcement cot of derivatives mansetions Ie should be aleolated using probebileysmayis ‘sed opon broad confidence intervals (eg standard deviations) over the remaining term of the sens "see “Recommendation 20: Danses” ofthe Group of “Thary Study 1993], which recommends dclonue of = information sboot management's stirade to anc hs, bow insraments ae wed, and bow sks ace monored sod onal — Accounting polices — Analyt of postions athe balince set de, yt of postions Sec 1995— Ams of the ere ik inert he pions, = For sesers only, adil informacion about ‘he exten of her actin fan rumen, See sho “Puble Diclonue of Risks Relited co Marker ‘Acoviy” 1994) "See "Kecommendinon 1: Ihe Kole ot Semor Mange- ment” of he Group of Thi Sad (1993), which ete: — Dealer nc end-esshould ase derivative ia ‘manner conestent with the ever ik management fad capil policies approved by their board of beecon. Thee police shouldbe reviewed st bus ness and murket circumotances change, Policies soverning decvsve te woud be clely defied incoding the purposes for which thee asscons te to be underaken, Senor mansgemene should {pprove procedure and coool implemen ese Poltetes, and management ata levelethould enforce them. see “Reconmenduion 9: Practice oF End-User” ofthe Group of Ty Seay (193), which ate As appropriate to the nature, site, and Complesty of thee dervnive acti, end-aert Should adope dhe tame valavon and marker Imanagemear practices that are recommended or Acaer. Specialy, they should consider repulely rmarking-to-mirket thei derivatives taneetiony for rk managemest purposes: periodically fore- cating the cash lovening and funding eequire- ‘mena acing fom their derivatives taneiesons {detaching + clestly independent nd author farve fonction to design and amure adherence to rudeness, REFERENCES Afidamt of W. Arthas Benson, ia W. Arthur Benin». Metie sellhat Cp. ol USD.C. 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