The Changing Use of Derivatives: More Hedging, Less Speculation

Bankers’ Trust: How they Lost Trust

Abstract

This case is about a financial advisor, Bankers’ Trust on whose advice, many companies losttheir money.
In the mid-1990s, Bankers Trust was one of the leading financial Institutions in themarketing of
innovative financial products like derivatives. Yet Bankers Trust's reputation took a pounding after the
bank was sued by several customers alleging various forms of fraud andracketeering with respect to
derivatives transactions they had entered into with the bank. FederalPaper Board Company, Gibson
Greetings, Air Products and Chemicals, and Procter & Gambleasserted that Bankers Trust had misled
them with respect to the risk and value of derivatives thatthey had purchased from the bank. The first
three cases were settled out of court for a total of$93 million. The $195 million Procter & Gamble suit
was settled at a net gain to P&G of $78million. But definitely the major damage was not financial but
something else- loss of trust andreputation. This was worsened when several Bankers Trust bankers
were caught on taperemarking that their client [Gibson Greetings] would not be able to understand
what they weredoing. Afterwards badly reputed Bankers’ Trust was acquired by Principal Group in
Australiaand rest by Deutsche Bank in 1998.

When Procter & Gamble and other companies lost their money in derivative transactions, they blamed
their advisor Bankers Trust for misleading them. Bankers Trust was a leading financialadvisor in Mid
Nineties. It established itself as an expert in the niche of risk management andinnovative derivatives. But
Non disclosure of risk and valuation of the complex derivatives led tolegal suits by four of its major
clients – Procter & Gamble, Gibson Greetings, Federal PaperBoard Company and Air Products &
Chemicals. Bankers’ Trust had to pay $171 million for outof court settlement of these cases. This comes
out as an example of poor customer management.While focusing on increasing profits, Bankers Trust
didn't pay adequate attention to makecustomers feel informed and at ease with their deals. On the
other hand, the clients werecriticized for not understanding their own derivative transactions and not
informing it to shareholders

Clients of Bankers’ Trust

Bankers Trust rendered its services to a number of clients. It usuallyhelped them to predict interest rate
movements and on its basis speculate in derivatives inanticipation of high profits. The details about its
services to them are the following:

Gibson Greetings

Gibson Greetings was a greeting card and wrapping paper manufacturing company. It wasconservative
company which was naïve to derivatives. It did not want to incur loss more than $3million through
derivative speculations. Over eight months in derivative contracts with Bankers’Trust it earned $
260000. This profit made Gibson comfortable about derivatives. After that thecompany entered into
around 29 linked derivatives to earn more profit and paid to Bankers Trustaround $13 million. These
complex derivatives had fancy names like ratio swap, periodic floor,spread lock 1 and 2, Treasury-linked
swap, knockout call option, Libor-linked payout, timeswap, and wedding band 3 and 6
.

As many of the contracts contained options, they incorporatedleverage (having fixed cost like loan).But
after some time Gibson started losing money whichwas much more than the maximum loss amount
specified by Gibson. Its losses increaseddramatically in response to small changes in interest rates due to
high leverage.When Gibsonsuffered from $17.5 million loss, Bankers Trust made it enter into another
contract that couldlead to reduced loss of $3 million or increased loss of $27.5 million.This bet also
failed andincreased the loss to $20.7 million After Gibson Greetings lost huge amount, it sued
Bankers’Trust.

P&G decided to go into high risk complex derivatives through Bankers Trust
which was known to be a top player in risk management. P&G had discussed
hedging by Bankers Trust using vanilla swaps. It entered into two such
contracts. These contracts were floating rate notes in Deutsche marks and
dollars. The bets were made on the assumption that the interest rates would
fall. P&G further upped the stakes by betting twenty to one in favor of an
interest rate fall.

There was the buzz that rates would indeed increase at some point and
therefore positions must be cleared before it did happen. In 1994, Greenspan
went ahead and did what the market was predicting. He raised rates. P&G lost
heavily. Its Chief Financial Officer claimed that they had no knowledge of the
intricacies of the contract and were thus unaware of the losses that could be
made. Bankers Trust on its part had not clearly detailed the underlying risk
inherent in their contracts.

P&G sued BT for $195million. BT claimed that P&G had in place its own panel
of experts to do interest rates forecasts and that they had not complained
when they made handsome gains. Eventually both the parties settled out of
court for a net of $78 million.
Air Product & Chemical

It also entered into interest rate swap, a derivative in which the valueof the transaction fluctuated with
changes in interest rates. As interest rates rose sharply in 1994,the value of the contracts dissolved, and
the losses mounted. Air Products and Chemicalscontended that the contract violated its corporate policy
against risky investments. It lost $107million. Bankers Trust had to pay $67 million to the company in
Out of Court settlement dealsSimilarly Federal Paper Board Company also entered into derivative
contracts to speculate onthe interest rates and lost $12 million.

Unawareness of Clients’ Management & Disclosure of Tapes

Most of the clients of Bankers’ Trust were unaware about the risk associated with the
derivativecontracts. Their business was totally different from financial derivatives and they were
notexperts of derivatives, still they took speculative positions to make money. They did not
knowanything about the valuation models and the details of derivative contracts they entered into
andwere totally dependent on the advice of Bankers Trust. The major issue in this case was bankerstrust
did not inform the risk related to the derivative products to its clients: i. e. What losses theycould face if
things would go wrong.At the time of huge losses, Bankers Trust misrepresented the loss to Gibson
because it exceededthe limit specified. Bankers Trust made Gibson enter into another contract in
anticipation ofrecovering money and getting more consultancy charges. Their efforts failed and they
have todisclose the loss which was much more than specified limit. Things complicated because
manytapes were found regarding the deal. Two Bankers Trust people holding an incriminating
phoneconversation were taped, caught in fact by an internal system that Bankers used to
monitortrades. These people were removed from company but the information was leaked to
BT’sclients which were suffering from huge losses due to the derivative contracts entered
throughBankers’ Trust.

Out of Court Settlements and acquisitionby Deutsche Bank

Bankers Trust was sued by its 4 clients. As the both Bankers’ Trust and the clients’ managementwere
criticized by Security Exchange Commission, they settled them out of court.The $195million Procter &
Gamble suit was settled at a net gain to P&G of $78 million. The other threecases were settled out of
court for a total of $93 millionincluding $14 million to GibsonGreetings. Apart from it they had to pay
huge amount to Securities Exchange Commission. NewCEO Frank Newman was not able to save the
company by the resulting reputation damage &lack of a natural client base. In 1997 to strengthen the
business and to grow in investment banking business, Bankers Trust acquired Alex Brown & Sons. Alex
Brown & sons was foundedin 1800 and was a public corporation since 1986. The bank suffered major
losses in the summerof 1998 when Russia defaulted. Many insiders believed that aggressive strategies of
Frank Newman and high lending of the bank were the main reasons of those losses. In November
1998,Deutsche Bank acquired Bankers Trust for $9.8 billion. The CEO received $110 ascompensation for
severance. In Australia, Bankers Trust was acquired by Principal Group fromDeutsche Bank and three
years later it was sold to Westpac. This organization is running in thename of BT Financial Group. Even
the Trust and Custody business that Deutsche Bank acquiredfrom Bankers Trust was sold to State Street
two years later.

This case raises a number of issues and questions related to financial advisors. The lesson to belearned is
what should be the duty of financial advisor to inform its clients?According toBankers’ Trust official "
“The loss of even one client is a stinging lesson’’

It was ironic that BT,a company that was considered by many to be a leader in risk management and in
innovativederivative products, lost so much of its reputation as a result of operational risk. An
enterpriserisk management program must balance the "hard side" of risk management (including
policies,limits and systems) and the “soft side” (including people, culture and incentives). Apart from
it,the organization should never give a chance to outsiders to point out on the moral values
oforganization. Sales practices, incentives and other things should be aligned to maintain thereputation.
Customers are the king, so companies should focus to delight customers in a long run by strong
customer relationship management. Otherwise one unsatisfied customer can hampergrowth of the
company

Another question is what is the duty of the management at the time of entering into derivativecontract?

uring the derivatives crisis of the early- and mid-1990s, one magazine illustration showed a dark, ghostly
planet exerting a dangerous gravitational pull on the known world nearby, depicting how trillions of
dollars in swaps, forwards, strips, options and other exotic contracts could topple ordinary stock and
bond markets.

Gibson Greetings and Procter & Gamble were shaken by immense losses on derivatives speculations in
that decade, while Orange County, Calif. was forced to file for bankruptcy as a result of its treasurer’s
failed derivatives bets.

Back then, many worried that corporate treasurers and other executives were being lured into high-risk,
leveraged derivatives bets by slick Wall Street salesmen who understood little more about these strange
products than their customers did. But disaster did not strike after all, and derivatives rarely make news
today. Did they fall into disfavor?

No, says Wharton accounting professor Wayne Guay. Derivatives are still among us. “The derivatives
industry seems to be fairly healthy,” he suggests. “The numbers don’t indicate any real decline in the
use of these instruments.”
Today, by contrast, many derivatives contracts are standardized, well understood and economically
priced.

What has changed, he explains, is the way derivatives are used in a market that has matured. “Twenty
years ago, it was a new type of market. Derivative securities were not that common.

Many derivatives are designed to be used conservatively, as insurance policies to hedge against the
possibility of loss in risky business environments. For example, a common derivative for hedging is the
forward contract, where a firm agrees to buy or sell some currency or commodity at a specified price
sometime in the future. For example, on Jan. 31, 2003, a firm might enter into a contract with another
party to buy one million barrels of oil on Jan. 31, 2004, at a fixed price of $20 per barrel. If the price of oil
on Jan. 31, 2004, turns out to be greater than $20 per barrel, the firm will make a profit on the
derivative and if the price of oil turns out to be less than $20 per barrel, the firm takes a loss on the
derivative. However, either way, the firm has hedged its oil needs by guaranteeing that it will only have
to pay $20 million to buy one million barrels of oil.

For most types of derivatives, minor price changes will not cause large price swings in the value of the
derivative. However, if firms enter into exotic and leveraged derivatives, minor price changes can lead to
very volatile price swings. This is what caused so much trouble in the high-profile cases a decade ago.

Guay and Kothari found that derivatives involving currency exchange-rate and interest-rate hedges were
the most widely used at the companies they studied, with contracts typically covering periods of
between one to five years. For example, says Guay, an American company might sign a contract with a
German supplier for a shipment of semiconductors to be delivered in six months at an agreed-upon
price in euros. But if the dollar were to fall in relation to the euro in the meantime, the cost to the
American company would go up.

“Clearly, the final amount they pay to that German firm is dependent on the dollar-euro exchange rate,”
Guay points out. “A company might say, ‘We want to lock in the price. We don’t want to be subject to
that uncertainty.’” So the Americans could go to a securities firm and purchase a futures contract to buy
euros at today’s price in six months.

If the dollar rises in value against the euro, the firm is still obligated to pay the agreed upon price for the
euros. In hindsight, the firm might wish it hadn’t entered into the derivative contract because it forces
the firm to pay more to acquire the euros than if the firm simply went out and bought euros on the date
it pays the German firm. However, the opposite is true if the dollar rises against the euro. In this case
the firm is pleased that it entered into the derivative contract because it allows the firm to pay less to
acquire the euros than if the firm simply went out and bought euros on the date it pays the German
firm. Regardless of whether the derivative gained or lost value in hindsight, the firm successfully used
the derivative to “lock in” the dollar cost of purchasing the semiconductors.

Aside from currency contracts, derivatives are common in many volatile markets, such as oil, copper,
steel and grain. A company that has taken out a variable-rate loan might use an interest-rate swap to
hedge against the possibility that rates would rise, while a company that has made a variable rate loan
might use a different contract to hedge against the possibility rates would fall. Some derivatives
contracts are standardized, others are tailored to the customer’s needs.

In most cases, Guay and Kothari found, the money that could be gained or lost through the derivatives
contracts they examined would be small relative to the firm’s size, even under the most extreme and
unlikely situations.

“Our results suggest that the magnitude of the derivatives positions held by most firms is economically
small in relation to their entity-level risk exposures,” the authors conclude. The median firm, for
example, held interest-rate or currency-exchange derivatives that equaled only 3% to 6% of the firm’s
total interest-rate or currency exposure. Generally, they add, derivatives bets are too small to have
much affect, positive or negative, on companies’ stock prices.

Given that the expense of maintaining a derivatives’ program is “not trivial,” it is unclear how the
benefits of using derivatives in small quantities outweigh the costs. One might expect that many
companies would forego hedging minor risks with derivatives because things are likely to even out over
time: Losses on one non-hedged position may be offset by gains on another, says Guay.
Guay and Kothari argue that their results may be consistent with companies using derivatives to fine-
tune overall risk-management programs that include other techniques. A firm concerned about
fluctuating exchange rates, for example, might set up an overseas factory that can do business in the
foreign currency. Companies can vertically integrate to gain some control over costs of supplies and raw
materials. Alternatively, rather than enter into company-wide derivatives programs, some companies
may allow mangers of individual operating divisions to initiate derivatives positions on their own. A
hedge may be large for the division but small for the company as a whole, Guay says.

But use of derivatives for speculation rather than hedging appears to be small. New regulations were
enacted after the early ‘90s disasters to require companies to more fully disclose their derivatives
positions. Boards of directors are more likely to be watching than they were a decade ago, Guay notes,
adding “For most firms, it’s not a time bomb ticking. “Even if they are using them in a bad way, they are
not using them in huge quantities.”