Time Magazine Takes On Asian Derivatives
By Robert Hunter
The last place one would expect to find a controversial piece of derivatives journalism is Time magazine. But its May 25 issue contained an incendiary article by Bernard Baumohl, entitled “The Banks’ Nuclear Secrets,” that seeks once again to blow the roof off a business known to most people only for its major disasters.
The three-page article asserts that “Shaky economies in Asia aren’t good places for delicate financial instruments like derivatives. The fires engulfing Indonesia could scorch American banks.” It proceeds to explain, with varying degrees of accuracy, the tenuous position major American banks are in as a result of the Asian meltdown.
Baumohl has a knack for describing events in the most sensational terms possible. “Derivatives are a kind of nuclear financial instrument,” he writes. “Under steady conditions they work well. But…like nuclear mishaps, there are no small accidents.” After a brief description of the history of the derivatives business, he concludes, “Parse the language and it means many banks have a new sideline: gambling.”
Hyperbole aside, Baumohl supports his assertion that the Asian crisis could push several American banks to the brink of insolvency with a bevy of statistics. Some are telling, others beg for more elucidation, but all have derivatives people muttering to themselves. He notes that:
- Chase Manhattan had $3 billion at risk from Asian derivatives at the end of last year.
- Bankers Trust has seen its nonperforming assets jump from zero to $330 million, with “the compass point[ing] to Indonesian and Thai clients.”
- The 25 biggest banks have more than $350 billion in credit exposure to derivatives.
- JP Morgan last year wrote off $659 million as nonperforming assets, “90 percent of which were derivatives from Asian counterparties.”
- A loss of one-tenth of the $116 billion in credit risk Morgan had at the end of last year could wipe out the bank’s equity.
- Chase has already claimed more than $1 billion in nonperforming assets.
- CIBC has almost $1 billion in gross foreign derivatives with non-investment-grade counterparties.
The statistical centerpiece of the article is an eye-popper: “And now comes the bad news. Some $10 trillion (yes, $10,000,000,000,000) in derivative contracts are set to mature this year for U.S. bankers, and the U.S. bankers are holding their collective breath to see which of their Asian clients will pay up. Many won’t.”
|“Banks have a large problem on their hands. We won’t know the severity for some time, but it could be massive.”
risk management consultant,
Numbers, of course, can be misleading. Baumohl never indicates, for instance, how much of the $10 trillion coming due this year is connected to Asia. One of the sources in Baumhol’s piece, contacted subsequently by this magazine, questioned the $10 trillion figure. “The numbers that are directly linked to Asia are not large,” he contends. “There’s some size there, but not to the degree the article implies.” And since $10 trillion undoubtedly represents the notional amount of the contracts reaching maturity this year, the actual amount at risk is much smaller. “Obviously some of the exposure is going to be lost,” he continues, “but the majority is going to be collected. If this is the worst thing that happens during our careers, then we’ll be pretty happy.”
But is the sky falling?
Despite the statistical ambiguity and apocalyptic tone, Baumohl’s core argument—that U.S. banks with derivative exposures to Asian counterparties face troubled times—is unassailable. The main woes in Asia stem from underdeveloped bond markets, which have caused corporates to rely too heavily on local banks for liquidity. This has been costly, since bank credit can only crudely approximate the efficient pricing mechanisms of a well-developed long-term debt market. When the Asian economies began to nosedive last fall, credit evaporated, causing immediate cash-flow problems. Since most Asian debt was denominated in U.S. dollars, the currency free-falls exacerbated the crunch, producing what many call the “double-whammy” corporate liquidity crisis. And the lack of efficient debt markets provided foreign investors with little alternative but to yank their funds from the Asian table altogether, compounding the problem still further.
The picture isn’t pretty for U.S. banks with exposures to Asian corporates. Since most of Asia is non-investment grade, U.S. banks that were wary of dealing directly with weak credit counterparties channeled deals through local banks, creating something of a tripartite structure. Many of the deals were what some derisively call “wrong-way” swaps, in which local companies, and therefore local banks, paid in foreign currency and received in local currency, hoping to ride the wave of the Asian economic miracle forever.
But the strategy began to unravel July 2, 1997, when the Thai baht started to collapse. Now, after 12 months of falling Asian currencies, Asian corporates are left with massive exposures to U.S. banks. The systematic deterioration of local bank credit quality—not to mention local corporate credit quality—has most big players biting their nails. “These banks have a large problem on their hands,” says Satyajit Das, an Australian risk management consultant who has many clients in the Asian market. “We won’t know the severity for some time, but it could be massive.”
JP Morgan’s huge write-off may be only the tip of the iceberg. To make problems even worse for U.S. banks, some of their deals to Asian corporates were channeled through Japanese banks. Near-zero interest rates for most of the 1990s forced Japanese banks to employ a volumetric approach to lending: income lost to low interest rates was made up for by the sheer number of loans issued, to debtors with ever-more-dubious credit standing. As a result, many Japanese banks have seen their own credit ratings slip of late, a result that worries U.S. counterparties. Moreover, big U.S. banks have made credit derivative deals with local banks throughout Asia—banks that are becoming less and less able to cover their ballooning exposures. U.S. bank mergers, meanwhile, are creating more concentration risk, which could exacerbate losses. And recent broken deals between Dharmala and Bankers Trust in Indonesia, and CSFP and Dijya in Malaysia, as well as the much-publicized JP Morgan problems in South Korea, show that contract enforcement is still a bugaboo in Asia.
Models of inefficiency
The Time article was on the money in one respect: typical derivatives models were incapable of predicting the Asian crisis. “Every once in a while,” Baumohl writes, “an asteroid does strike or countries blow up. These things aren’t fully factored in the modeling.” That doesn’t surprise many software vendors who try to develop models for such disasters. “Exchange rates have moved much more than anybody expected, which, by the way, is almost perpetually true of human forecasting,” says Ron Dembo, president of Algorithmics. “The risk is always greater than people expect.
If you took a CreditMetrics or RiskMetrics approach to measuring market exposure, you would not have adequately captured the exposure in your credit book.” In Korea, he explains, Korean banks made loans to Korean corporates who had to pay back dollar-linked debts. He’s certain that those Korean banks were only looking at historical information to determine what exposure was appropriate. The cost of the loan, then, was clearly not adequate to cover the risk. “If you live in a backward-looking world and only look at history to determine your future exposure numbers, you can easily find yourself in a situation where you’ve drastically underestimated your credit exposure—especially with the leverage effect in derivatives,” he concludes.
Leslie Rahl, a principal at Capital Market Risk Advisors, notes that certain what-if analyses would have helped U.S. banks manage their Asian risks better. Her firm examined the Thai baht devaluation of the last year against the Mexican peso devaluation of 1994–95, and found that the baht move was only about half as large. “If you knew you had some currencies [such as the baht] that tended to be pegged and stable, you could have come up with a stress test that asked, ‘What if the currencies destabilize, and the magnitude of that destabilization is only half as bad as the peso?’ If you did that, you would have seen these problems ahead of time, and you would have done things quite differently.”
|“In a backward-looking world, you can drastically underestimate your credit exposure.”
Rahl points out that the Asian crisis, like all economic conflagrations, is a drastic departure from the historical norm. “What has happened in Asia is a real paradigm shift,” she says. “If you look at the way these currencies correlated and behaved before July of last year, and the way they’re performing now, something rather dramatic has happened. And people who are still wedded to a purely historical view of volatility or correlation will once again be surprised.” But for all the bad-mouthing of historical-based modeling, Rahl notes, 1998 shares certain similarities with 1994—the potentially disastrous leveraged currency deals of today look eerily similar to the leveraged interest rate blow-ups of days past.
Indeed, many believe the skies are threatening. “There is tremendous credit exposure in Asia,” warns Algorithmics’ Dembo, “and it’s not off the wall that there would be a big deterioration. It looks quite likely. But the top-notch U.S. banks are quite good at diversifying and managing risk. I’d be surprised if they had concentration risk in Asia that’s unacceptable. But I also wouldn’t be surprised if they had underestimated the cost of their credit risk.”
“Asia is the definitive proof that interest and foreign exchange ratescan be highly correlated with credit spreads and defaults,” says Donald van Deventer, president of the Kamakura Corp., a risk management consulting and software development company. He believes the events also demonstrate the need for mark-to-market collateralization or margin requirements for borrowers who would suffer big drops in credit quality in response to interest or foreign exchange rates.
If the Asian crisis can teach bankers anything, it’s that the distinction between market risk and credit risk is much blurrier than previously thought. “Until the Asian crisis,” says one software developer, “it was merely an academic exercise to link market and credit risk. Today, bankers can’t duck from this reality. Asia is clearly a case in which a single market factor brought down an enormous amount of credit.”
FX Study: Big Corporates Have Much in Common
In an effort to learn more about the foreign exchange risk management practices of other major companies, General Motors recently commissioned Greenwich Treasury Advisors, a Greenwich, Conn.-based risk management firm, to survey some other top companies. Green-wich asked 31 companies based in the United States, Europe and Japan with average sales of $50 billion more than 300 questions concerning their FX risk management strategies and practices.
The study found a number of similarities among the companies, which include Ford, Chrysler, Daimler-Benz, British Petroleum and Toyota. Among them: Most have a strong focus on hedging cash flows rather than profit-and-loss earnings. (Some 70 percent hedge pretransactional FX exposures, while less than 30 percent hedge anticipated P&L earnings.) More than 90 percent of the firms employ a centralized approach to risk management, and some 90 percent use either an FX risk committee to manage corporate risk parameters or a middle-office group to track policy and procedure compliance. In addition, most firms use a long-term hedging time horizon—20 percent hedging beyond two years, 10 percent hedging between one and two years, and 40 percent hedging on a 12-month rolling basis, with the rest hedging within the fiscal year.
|“Each company has thought through its FX risk management policy, adapting common FX risk management techniques and its own company’s risk tolerances.”
Greenwich Treasury Advisors
There were some significant differences as well. “We found that the companies separated into three distinct groups,” says Jeff Wallace, managing director of Greenwich. “Forty percent are ‘passive hedgers,’ who have no FX views. Instead, they hedge according to fixed rules. They are more likely to be American companies and are much less likely to actively use FX options. A quarter are ‘active hedgers within limits,’ who hedged below specific position or value-at-risk limits.” The remainder, he says, are “aggressive hedgers” who have a great deal of hedging discretion based on their market views. Of these companies, most are European multinationals that actively trade options, including covered and naked options.
“Overall,” says Wallace, “the most impressive thing about this group is how well each company has thought through its FX risk management policy, adapting common FX risk management techniques to its own particular industry’s economic circumstances and its own company’s risk tolerances. But a common concern was the need to do more risk analysis of existing hedge positions—particularly for the active and aggressive hedgers.”
For a copy of the report, call 203-531-0835.
London Clearing House To Clear Swaps
The London Clearing House has decided to join the over-the-counter derivatives clearing business. Beginning next June, it will launch SwapClear, a mechanism designed to clear plain vanilla interest rate swaps and forward rate agreements in the major currencies.
The process will work as follows: When two banks have agreed to terms and confirmed a trade with each other, the contract will be sent to SwapClear, which will run a series of checks on the deal and become a counterparty to the trade. From that point on, the banks won’t have any exposure to each other, but rather to the LCH.
SwapClear is designed to reduce the capital requirements of counterparties and allow for easier management of credit lines and more efficient use of collateral. The LCH expects to offer cross-margining with London International Financial Futures and Options Exchange (LIFFE) products, which could free up even more cash for customers. And since clearing and settlement will be handled by a third party, customers could save a bundle in back-office costs.
“We’ve focused on the very standardized end of the OTC market, which by and large has been commoditized to such an extent that people are not making huge profits. SwapClear will provide capital and credit efficiency and bring back-office standardization and other benefits to our customers,” says Sara Williams, director of business development at LCH. “We’ll extend the product range later, to include such structures as cross-currency swaps and caps, collars, and swaptions.”
Since 45 of the world’s 60 largest swaps dealers are LCH members, SwapClear could see dramatic volume right away. “Almost all the world’s major dealers already have a relationship with us,” says Williams.
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