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The Two Faces of Kevin Hudson

The Bankers Trust–Procter & Gamble debacle was a critical turning point in the derivatives market. In our 1995 newsletter article, "The Two Faces Of Kevin Hudson," our reporters combed through hundreds of pages of court documents to present the definitive analysis of the scandal. Although only a few hundred copies were published, the article has been photocopied extensively and used as an object lesson for anyone who wanted to learn from the mistakes of the past. On our fifth-year anniversary, we republish it for a new audience.

By John Thackray with research Assistance by Carol Bere

Great storms all start as small clouds, and great scandals often begin as routine business. So it was with Bankers Trust and Procter & Gamble. In the early 1990s, the relationship between the two was cool and distant in most areas, like commercial lending, mergers and acquisitions, and underwriting. In 1991, when the bank's affiliate, BT Securities, began avidly courting the Cincinnati-based packaged-goods giant for a share of its derivatives trades, success seemed unlikely.

But in late 1992, the relationship warmed a bit. BT Securities got a line into the company's treasury, which had recently been made an independent profit center. Their first transaction, a January 1993 Mexican peso-linked deal, soon led to a broad agreement for derivatives contracts. But again, P&G was not a particularly responsive client.

BT Securities presented a number of possible transactions in May, July and August 1993—all of them scorned. That was soon to change. On October 4, 1993, a BT Securities managing director named Kevin Hudson and his colleague, Mark Schindler, sent another routine memo to P&G that presented two swap ideas containing, the bank assured, "superior alternatives” to the plain-vanilla variety.

P&G seemed genuinely interested this time. Hudson, a persuasive, smooth-talking and self-assured salesman, went on the attack. He followed up with a call to Dane Parker, a P&G treasury analyst. This would be a "profitable” swap, he assured Parker, because it was structured with the company's requirements in mind. He promised the client the potential for an "enhanced coupon while assuming risks that you are comfortable with.”

Over the next few weeks, Hudson was the consummate suitor, explaining in cool terms to Parker and other P&G analysts how the swap worked. He outlined that P&G could probably lock in its target level for return in "just two months,” and if interest rates start jumping, not to worry. "You can tear up the trade,” Hudson said. "You say, ‘I don't want to get any greedier than that,' and ‘let's just walk away.'”

But if Kevin Hudson presented to Parker the face of a calm and reasonable banker, he showed a rather different face to his colleagues and friends. This was no ordinary deal; it was a highly lucrative, drop-dead career-maker. It would be the biggest deal in 1993, he boasted. So if Hudson was later to come off sounding like any fast-talking car salesman, well, this was Master of the Universe stuff.

On the phone to his then-fiancée and now wife, Allison Bernhard, also a Bankers Trust employee, Hudson recalled the deal's closure. "I was so smooth,” he said. "It was like, yeah, no problem...I said, you know, let me just talk to my trader. We'll pull up the model, and ah, let me get back to you with some prices...We set ‘em up.”

"It's like our greatest fantasy,” replied Schindler.
"I know. It is. It is. this is a wet dream,” said Hudson.

Hudson shared his excitement about the deal with his buddy Schindler. "You're looking at an $8 million trade,” Hudson said.

"It's like our greatest fantasy,” replied Schindler.

"I know. It is. It is. This is a wet dream,” said Hudson.

Hudson's dreams aren't so pleasant these days. He is at the heart of the extraordinarily nasty legal battle now being waged in the U.S. District Court for the Southern District of Ohio over soured derivatives deals between P&G and Bankers Trust.

Towering evidence

Hudson's revealing conversations were among the 6,500 audio recordings that have been introduced as evidence. The telephone conversations, between bankers talking to clients or to each other, were recorded by Bankers Trust as part of its normal monitoring system. The evidence is towering: it also includes 28 depositions and a 400,000-page collection of faxes, memoranda and deal documentation.

Each side claims its selections from this evidentiary pile tells the truth. P&G contends that Bankers Trust employees are outright crooks who deliberately misled or deceived the company into buying the complex derivatives. On September 5, the company filed RICO (Racketeer Influence and Corrupt Organization) charges, alleging that it was among a series of clients Bankers Trust ripped off. P&G claims the swaps created excess interest costs for the company of $195 million.

For its part, the bank insists the evidence shows that the packaged-goods multinational is a sophisticated financial player that made colossally stupid market calls—and now wants to blame the dealer. "What P&G has done is to use material we provided to manufacture a distorted view of transactions, markets, individuals, and the corporation in a manner designed to obscure its own accountability,” a BT Securities press release said, when the new documents were unsealed on October 3, 1995.

But both sides agree on one thing: that Kevin Hudson played a leading role throughout two key swaps. To P&G, Hudson is a punk, a braggart, a liar who cost them millions of dollars. BT Securities says that Hudson's conduct was legal and proper, even if he might have overreached at times (for which he was reprimanded).

The real Kevin Hudson will have to be determined by the court from the mass of evidence (but judging from the account that follows, albeit one from biased and fragmentary evidence assembled by both sides, he clearly wears a number of faces). In either case, the tapes and depositions have given the world a first-time-ever, gritty and graphic inside picture of the drama of proprietary derivatives deal-making—and, when disaster struck, deal unraveling.

It is not a pretty picture. P&G seems remarkably tin-eared, naive and looking to pawn off a bad bet. Hudson is full of hubris, slick and maybe too quick to make a buck. For better or worse, Kevin Hudson will leave an indelible mark on public perceptions of the derivatives trade.

The pitch

One swap that Kevin Hudson and Mark Schindler insisted had "superior alternatives” was a proprietary leveraged rate swap. Along with other bells and whistles, the swap involved interest-setting formulas based on the correlation between five- and 30-year bonds. It's called a 5/30 swap. The attraction for P&G was that this could significantly reduce medium-term financing costs. Bankers Trust subsequently outlined the 5/30 swap in writing along with a printed time-decay analysis.

11/2/93 P&G does 5/30 swap for $200 million notional
1/25/94 Swap extended by two weeks
1/26/94 BT proposes DM swap
2/4/94 Fed raises rates a quarter of a point
2/14/94 P&G agrees to a $100 million DM swap with BT
2/15/94 P&G learns the 5/30 tear up are now CP+400
3/10/94 $50 million closed out at CP+1055
3/14/94 Another $50 million closed at CP+l198
3/29/94 $100 million closed at CP+1412
4/11/94 DM swap unwound for a loss of $54 million

The five-year debt was to have a floating rate for a six-month "at risk” period, and then set to fixed for the remaining four-and-a-half years. In the first six months, P&G was to pay Bankers Trust a rate of CP (commercial paper) minus 75 basis points. In return for this below-market rate, P&G faced grave uncertainties as to where rates might be six months out. Still, P&G had some insurance against a run-up, in the form of a six-month option to set the rate at any time. The goal of P&G treasury was to get the four-and-a-half years' money at CP-40.

Hudson, understandably, played this early lock-in feature to the hilt. Faxes by the bank showed that if P&G were to lock-in one month into the transaction, it would already have obtained a 20 basis point advantage.

Hudson told Dane Parker: "...This is the type of thing we don't even have to live with for six months. We can live with it for three months and take it off with most of the value there.” And he added in a subsequent fax that P&G "should be able to lock-in its target level of CP-40 basis points, assuming stable rates and volatility, in just two months. As we have stated, the view P&G is expressing is actually much shorter than six months.”

The caveat "assuming stable rates and volatility” seems to have passed across the P&G corporate brain without raising an electrical charge. Kevin Hudson's keen salesmanship and assurances perhaps had a tranquilizing effect.

He admitted to some puzzlement. How could a sophisticated financial player, with $5 billion in debt, total derivatives positions upwards of $2 billion, and which had close relations with major dealers like Goldman and Merrill put on such a dangerous trade? Yes, he was "psyched” at the prospect of the huge deal, he told his fiancée, but he was also intrigued by P&G's decision-making. He mused, "It's not even the money. It's that P&G would do this.”

"What did you say?” asked Bernhard.

"OK. It's the money,” he said, admitting the preeminence of greed over intellectual speculation.

On October 28, he engaged in a phone conversation with Dane Parker to walk him through the transaction and, it seems, to continue to gain his confidence.

The sale

"Okay—cool. Have you got your spreadsheet up?” he asked Parker.

"Looking at it.” Parker replied.

"Why don't we just sort of run a first scenario, why don't we just give you updated pricing so you can input the new put strike and the new five-year strike? As the market sold off, this thing has moved in your favor so your bond put strike right now would be 99.56.”


"And your spread always stays constant at 75. You can play around with that, but the reality is the spread we start with is CP minus 75.”

"Yeah, that's great.”

"And then you have complete flexibility just to go to the green boxes and change your yield, and that will change all the yields above and below it and also change your bond price, and that will change everything for you automatically,” said Kevin in an attempt to explain the correlation of the five- and 30-year interest rates.

"Those are just the standard bond prices?” asked Parker. "That's what the yield would be at around that price?”

"Exactly. We've already done the pricing, we've done the yield conversion for you.”

"Okay. Great.”

"Because that is a big pain in the butt to have to do that,” Kevin said.

Later the conversation focused on interest rate scenarios, a topic on which Parker clearly thought himself knowledgeable. "I'm more comfortable with the five-year than I am with the long bond,” he said.

"Well...the whole key is that you know you have so much room on the five-year. Remember what's important here is, the bond could trade well beyond, let's say 6.30, but as long as your five-year remains relatively stable or doesn't trade off massively, you're looking at a put with no value. So you're still going to be flat or CP minus 75, somewhere between the two,” Hudson said.

He went on to explain that earlier in the year his department had been pushing a 2/30 structure, but that as short-term rates fell sharply clients were attracted to the more stable five years. "We just kept adjusting the structures to peoples' comfort levels on the yield curve.”

"Gotcha,” replied Parker. "I'm comfortable with five years because, ah, at this point, I sorta see it, almost like a pivot point yield curve.”

"I agree...sort of a fulcrum.”

"The 30-year kind of flags up and down at the long end, and short rates are certainly sensitive to any Fed announcement or any of that stuff. It seems like the five-year is almost sort of a pivot in there.”

"You're right,” said Hudson. "I mean, the only way that you would run into trouble with the five-year is if you saw an absolute shift-up in the entire yield curve of about 75 or 80 basis points. And if you say, do I really envision that happening given all the economic numbers we've had recently, even GDP, that's where you'd have to have Fed tightened, you'd have to get...strong inflationary numbers and the entire curve would have to shift up to move the five-year because it's sort of in the middle.”

Magic parachute

"Yep. Well, for me the key too is the six month thing,” said Parker. "I think even if we get a quarter of inflationary numbers the Fed isn't going to jump yet.”

"That's right.”

"I think they'd wait.”

Parker's concerns weren't totally eased, but, as if hypnotized, he returned again to the "six month thing”—the early set bail-out option—looking for reassurance. Hudson gave it to him, telling him he could just walk away and have "CP less 40 for five years.”

Parker bit: "I like this, and I like the bet. Looking at that time decay analysis now, heck, it can last for three months. If rates are somewhat stable, you know, we could set at CP-55.”

"Yeah. I have to say that I've lived through several of these trades with accounts this year. We started using this structure to get enhanced coupons back in May, and we've lived through several tranches putting them on, taking them off. You have a lot of flexibility with this type of transaction. I mean the nice thing is, I'm so happy rates have backed up because you can put the thing on. You get the slightest rally and you can walk away from this very, very quickly. Or, because your view hasn't changed, you can hang in there and try to get as big a spread as possible.”

Like any good salesman, Hudson hammered home the early set option: "Three months into the trade, you say, ‘Look, I'm happy. I want to get rid of the risk here. Let's just lock it in at CP-40 and walk away.'”

Hudson was jubilant. "I just took the biggest trade of the year,” He said.
When his boss, Jack Lavin, was informed, lavin said, "I think my d*** just fell off.”

Parker asked: "We're paying CP-75 for six months, and then what we pay for the next four-and-a-half years depends on when we get out of it?”

"Exactly. Exactly.” said Hudson.

"I like this,” Parker responded.

P&G more than liked it. Until now, Hudson had sized the deal at $100 million notional. P&G not only agreed to the swap, but doubled the ante. Naturally enough, Hudson was jubilant. "I just took the biggest trade of the year,” and made $7.6 million, Hudson announced in a call to his fiancée. And when his boss, Jack Lavin, was informed, he told Bernhard that Lavin said, "I think my d*** just fell off.”

A colleague, Ari Bergmann, added to the congrats, telling Hudson, "Kevin, you are unbelievable.”

Hudson boasted that now he'd be able to get P&G into a lot more trades. "This is a new customer,” he told Bergmann. "That's the key. A customer that has never done structured leveraged proprietary trades before. This is it.”

Client is comfortable

Hudson continued wallowing in his good fortune for some time—too long perhaps. He made some comments that P&G later seized on as evidence of deliberate deception. Bernhard asked Hudson why P&G did the deal. "We were just spending so much time with them...getting them comfortable and...giving them the pricing model. The sensitivity model wasn't a pricing model...That did it...That thing showed them they were paying CP plus 20 percent.”

"They would never know. They would never be able to know how much money was taken out of that.”

"Never, no way...That's the beauty of Bankers Trust,” said Hudson. "P&G doesn't understand selling leveraged options and stuff. I mean, that's not their job to understand that. Their job is to say, ‘Here's my funding target and here is the risk I'm willing to take.'”

"What are you going to do with their mark-to-market on this thing?” asked Bernhard.

"I'm gonna reserve the shit out of the P&L...And just leak it in over time and say a prayer each night for a rally the next day...”

In this conversation, Hudson admitted that he paid P&G only half of the $7 million value of the put option on $3.4 billion of long bonds the bank now owned. When he told Bernhard that it was leveraged at seventeen times, she was flabbergasted. "Oh my ever loving God...Do they understand that? What they did?”

"No,” replied Hudson. "They understand what they did, but they don't understand the leverage, no.”

"Are you letting greed get in the way of business decisions?” Asked bernhard. "I hope that these people don't get blown up. ‘Cause that's the end of the gravy train.”

Bernhard, sounding baffled but beginning to catch on, asked Hudson the critical question: "How much did you tell them? What is your obligation to them?”

"I tell them if it goes wrong, what does it mean in a payout formula. ‘Here it is. It went wrong. You were wrong. You were really wrong. Do you understand how wrong this is?'”

BT's weak controls

Bernhard wasn't alone in worrying about the deal. Bankers Trust colleague Alok Singh raised some questions directly to Hudson. Hudson defended himself by asserting that P&G treasurer, Raymond Mains, knew all the details, because he'd signed off on it.

Singh wasn't satisfied. "You know, he's signing off on a lot of different things. I would prefer...having a much more regular dialogue between us...Obviously that must have taken a month or whatever it did of your persuading them...Just kind of struck me as being not necessarily the right way to do things.” (It would later turn out that Mains did not read the documentation upon signing, and that the documentation had no reference to an early set parachute.)

The prayed-for bond rally did not occur. While interest rates gyrated with uncommon vigor, Hudson proposed that both the bank and client earn a little more by extending the at-risk period for the floater by two weeks.

Soothingly, he said: "You're just kind of adding a little bit to the till...The same amount of time has passed, you get the same degree of time decay, but you would be getting out 11 basis points better.”

Ten days later, he made the same pitch. Parker, acknowledging he didn't know enough about pricing to decide, replied that an upcoming Treasury five-year auction may see yields "back up a little bit.” He wondered if the better strategy might not be to wait and see.

Theoretically, yes, said Hudson, while warning of risks with trying to time it right. "That's what my job is—to kind of give you some advice on what your options are—then you can pick and choose.”

Trouble brewing

Parker replied, "We're sure happy you're keeping on top of this deal.”

P&G agreed to the two-week extension, and Hudson told Bernhard the news. She wasn't exactly overjoyed, and said so in a remarkable exchange. "I thought you weren't going to do that,” she snapped.

Hudson explained that he "got more comfortable with the market today.” When asked how much the two weeks is worth, Hudson said, "A million to them, two million to me.”

"You're headed for trouble...It's gonna blow up on you,” Bernhard responded.

"I'm a glutton for punishment, and...l'm rollin', man, I gotta make money here.”

"You're not gonna have a job, you're not gonna [have] customers to make money with...Do stuff like that all the time, you're gonna blow ‘em up...You're getting greedier as the days roll by.”

But Hudson seemed to be relishing his new Master of the Universe role. He told Bernhard later that he didn't execute the extension until right after the housing market sold off for 10 minutes. The result: "I gave them something more than they left me an order for...I think it's something with the Christianity thing coming through, but I'm not going to let it get a hold...”

Although P&G would like us to think of Parker as naive and gullible, some facts suggest otherwise. One of the more puzzling aspects of the case is how a fairly junior person in the treasury was allowed to keep this transaction so cryptic. Not only did Parker fail to ask for the 5/30's mark, but he seems to have fixed this internally so that nobody—auditors included—asked for this data, even at year-end.

In late February, both men in different ways danced around the issues of valuation. Hudson began the discussion, saying that the best way to think of the 5/30 is not to say "where is the value today? Rather, the best way is always to look at the sensitivity tables or charts that we provide and say ‘Look, if it goes here. This is the risk I'm looking at.'”

"Thing with that though,” Parker countered, "is that you're looking at it before the strike date. If you've got a swap on, the rate's already been determined. You know your risk is already sort of set.”

"That is true,” said Hudson.

"Now before that strike rate, the whole risk thing is kind of fuzzy—that is difficult.”

"It is difficult,” Hudson agreed, "because it's a lot of moving parts.”

Life's A Bet
"Was the 5/30 transaction in essence a bet on interest rates?” P&G's Dane Parker is asked in a deposition.

"I believe every transaction to be a bet on interest rates. The 5/30 transaction turned out to be a leveraged bet on interest rates.”

"In other words, you bet wrong.”

"That is correct, yes.” Later, Parker elaborates: "Let me clarify my version of bet. Any financial market participant will explain that fixed rate debt is a bet as well. And if it had to be marked to market, it would cost substantial premiums above $100 million...It was not intended to be a bet any different than taking the floating rate risk that we had already taken...Bet brings up words of gambling.”

Parker is then asked to recall the moment when the terms of the early set formula are known to him on February 4—the day when (in the wisdom of hindsight) P&G wishes it did a tear up.

"To the best of my recollection, at that point we were informed that the spread was going to be 100 basis points above commercial paper.”

"So it's your recollection that they came up with the same calculation that you had come up with?”

"No, my recollection is they had told me that the spread was different than the spread I had calculated. And immediately [they] responded by saying that simply allowing a few more weeks to pass would bring it back to the levels that I was anticipating and I did not pursue that further.”

Valuation impossible

Parker seems here to wash his hands of the valuation issue. He says, "I'm not going to sit down and try to value all the options along with it...I think that is impossible.”

"I agree with you one hundred percent,” said Hudson. "You don't want to value the options because that's ludicrous. I mean, that's not your job. I don't, you know, build the models myself that value the options. Your job is to have a feel for the sensitivity of the positions. Then you're doing your risk assessment.”

"You know I actually didn't publish any value for this particular trade.” And Parker adds that he won't try to determine a value "until after we close it out or until the actual rate is set.”

"Right,” said Hudson.

"Because I'm not sure you would help anybody's understanding if I did publish something anyway.”

Hudson laughed.

Meanwhile, Hudson was hard at work pushing another swap proposal for P&G, a U.S. dollar/DM swap worth $100 million notional. Its virtues, he said, are similar to the 5/30s—"a lot of time decay and unwind in it, you know, the spread component early.”

As always, he detailed his sales pitch to his fiancée. "I was going over ‘em, shooting the shit with them, saying, you know, you really have to start looking at European rates, blah, blah, blah. I give them the whole spiel,” he told her, adding, "And I bet you I can get it done and I bet you I'll make another eight million bucks.”

Hudson figured that his total deals for the year added up to $25 million. What was more, if P&G did the projected DM trade, he vowed to take four points out of it.

Bernhard again jumped on him: "You've got to calm down.”

"I'm not calming down, man, I'm on a roll,” he said.

"Are you letting greed get in the way of business decisions?...I'm amazed...I just hope that you're right. I hope that these people don't get blown up. ‘Cause that's the end of the gravy train.”

"Yeah, well, I'll be looking for a new opportunity in the bank by then anyway.”

Hudson's hubris was such that even as the tide started to change, he sloughed off any potential bad news. On February 4, 1994, Hudson told Bernhard that the 5/30 was down about $17 million but he wasn't worried. "That's not much. I've had ‘em down $25 million before,” he said.

"Are they dying?” she asked.

"They don't know.”

"They're not asking?”


"Oh shit, God help you if they do.”

"That's okay, let me just get the DM trade done first and then they can ask.”

That same day the Federal Reserve raised rates 0.25 percent. P&G recognized that it had misforecast the direction of rates and now got ready to pull the parachute. But P&G was in for a surprise. It soon learned that the early exercise option would not be priced below CP, as it had assumed all along. The BT quote reflected the latest market conditions—and that put it at CP+l00 until maturity.

But remarkably, and inexplicably, P&G did not exercise the option and walk away from the deal. If they had simply torn up the deal, they would have gotten CP+l00 on $200 million over four-and-a-half years—a merely minor embarrassment of $4 million.

P&G subsequently made the alleged duplicity of the early set a major platform of its case. But the company acted like anything but an aggrieved party. Three days after the Fed rate hike, P&G's Parker seemed no less like clay in Hudson's hands than before. He asked Hudson about the 5/30 coming due in May and accepted his view that there was a "lot of comfort room here.”

Hudson added: "Of all the people who are in 5/30s with us yours with the 5.78 strike is the highest, so it's the one with which I have the most comfort.” He indicated that P&G should sit tight. Parker asked what would happen to five-year rates if the Fed tightened another 25 basis points.

"If we get to the level where we're uncomfortable, we can, you know, our job here is to constantly reevaluate and restructure positions.” The next day Hudson complained to Bernhard that the market is "crapping out.”

"If this keeps on happening this is just gonna be ugly beyond words,” she said.

"I know,” he replied.

The following day, in a conversation with Lavin, Hudson again implied that P&G was in the dark over the extent of its potential problems. When Lavin asked about a 5/30 with Sandoz, another client, Hudson replied: "Sandoz is fine. I mean, they know what it is. [Laughs.] I mean tough shit, they know what it is. It's the other clients I'm worried about. I'm worried about Air Products. I'm worried about P&G. I'm worried about everybody.”

Well, not too worried, it seemed. Again, Hudson said that he wanted first to win P&G's DM trade proposal. "Then we can start the deal with the other one later next week.”

"Right,” said Lavin.

Hudson, indeed, landed the deal. P&G entered into a DM/$100 million swap with band strike levels at 4.50 and 6.01. "A great trade,” he crowed to Parker. "I think all our positions are very good positions, but this one, I think, has the potential to be a real winner very quickly.”

But once again Hudson had to deal with doubters within BT Securities. One employee named Lee Barba really irked him, he told his fiancée. "Kind of sits there looking at me like, uh huh...[asking] ‘At what level was this approved? And how does the approval process go? And who knows about this trade in the company? And are they really that sophisticated?' I'm like: ‘Lee, they are really sophisticated. I got it approved at the treasurer level. It took three weeks to get approval, and I made them $7 million so just relax.'”

Parker still seemed oblivious to hudson's warning shots.
"Fundamentally, we don't believe that the five year is going to be higher in three months,” he said.
"Although, you know, fundamentals haven't proven to be the driver behind the makret lately.”

By mid-February, P&G's treasury team still seemed blissfully unaware of the full implications of the pricing on the early set provisions, but they were nonetheless confident that they could predict interest rates. They avidly read and believed interest rate forecasts from Goldman, Morgan and Merrill indicating rates had overreacted and swaps costs should improve. The upshot: the decision was made to hold off until the automatic set kicked in at the middle of May.

On February 22, Hudson and boss Lavin conferred over the P&G deal, debating how and what to tell the company about the latest on its swap. "I've got to call P&G and give them their mark,” estimated at $38 million. Lavin suggested that maybe rates could get worse and P&G should lock-in that day at CP+460–470.

"I don't think they know it's $50 million, Jack, no. $38 million, no, I don't think it's that number at all. So I'm going to tell them this morning, I'm not telling them, it's CP plus 4 percent.”

"That translates to what?”

"$38 million.”

"They can figure that out.”

"Yeah, they can figure it out, but that's the way I'm presenting it. I'm not telling them that they owe me $38 million.”

Hudson dropped the bombshell, or at least his sanitized version, in a phone call to Parker that day: "I just want to make sure that you are all aware that it's a leveraged position and if this thing starts to go against you all...we're going to want to get out at a time when you are all comfortable. If you were to say, ‘Where are we if we were to set this today,' the number is much higher, and that's because of volatility.” After saying he wanted to "do everything [he] could to keep P&G in a comfortable position,” Hudson let it out: that day's get-out price was CP+460. On the other hand, he said, there would be an argument for doing nothing based on tracking the five-year forwards, and if the long bond also stayed stable, then at the set period P&G might set at CP-32.

After some brainstorming on the interest rate outlook, Hudson went on: "The most important thing is that we just hold on, that we just keep the dialogue open and you tell us when things change...The thing to remember is that when rates back up a lot like this, and you move closer to the strikes on the short leveraged option position, the time decay on the option gets huge so every day that goes by the thing starts to deteriorate...I'm not saying like just hold for time, but it does work in your favor quite a bit.”

"The relative impact of this is not huge,” Parker observed.

Hudson agreed, apparently assuming P&G had gotten the unpleasant message. Checking in with Lavin later in the day, he assured his superior that P&G is "fundamentally fine. They know their mark is $40 million against them.” To Bernhard, he repeated the theme. "I spoke to them for thirty minutes. I gave them the sensitivity. I gave them the marks. I walked them through everything.”

But the next day, February 23, Parker still seemed oblivious to Hudson's warning shots. He told the banker that P&G would like to get out close to CP flat, and seemed to think that it wasn't impossible. "Fundamentally, we don't believe that the five year is going to be higher in three months,” he said. "Although, you know, fundamentals haven't proven to be the driver behind the market lately.”

He went on: "I think we're gonna hope that some fundamental values come into play here pretty soon,” adding the following day that "We're pleased we extended the maturity because I think the longer we wait, the better off we are going to be in a sense.”

Bad times

Hudson's anxiety seemed to be growing daily, however. He told Bernhard that it was the worst month in world financial markets that he'd ever known, and then he turned sardonic. "Here's the positive side,” he said. "I've buried my clients so much that it's going to take me four years to trade them out of this loss...P&G, well, we're down twenty million a year for the next five years. How are we going to trade our way out of that one?”

"Right. Okay. Yeah, that's fine. Okay, okay, okay, okay. Holy crudola! This is just unbelievable!” said Parker.
"I ask myself if it can get any worse. But that's what I've asked myself a lot lately.”

P&G's predictions turned out to be flat wrong. Rates surged. By March 1, Hudson and Parker were bemoaning a market meltdown. Although P&G still had more than two months to run at CP-88 before the automatic set, the quoted price of an early set had now gone up astronomically to CP+844 that day. Hudson made further projections of how market moves would affect the spread set, up to the point where it would be CP+l176.

"Right. Okay. Yeah, that's fine. Okay, okay, okay, okay. Holy crudola! This is just unbelievable!” said Parker. "I ask myself if it can get any worse. But that's what I've asked myself a lot lately.”

"We ask ourselves that constantly. This is probably the worst sell-off we've ever seen so far in one day—fifty ticks on the long bond,” Hudson moaned.

Within the bank, there were signs of a growing anxiety and perhaps embarrassment not only at the 5/30, which was down $53 million, but over the DM swap, which also proved to be a very mistaken bet. Lavin and Barba asked Hudson for assurances that treasurer Mains of P&G knew the exact amount of the losses. "They are definitely aware that they are down fifty-three on one...They are probably not aware that the number would be down forty million on the other,” Hudson told them.

Final exit

Hudson finally seemed to adopt a strategy of getting the client out of the swap, if possible. He began to urge caution, hoping to lead P&G toward a realization of the hopelessness of its position. But being a salesman he could not talk turkey, and so his language had mixed messages of anxiety and reassurance. "My feeling is that a prudent risk position is to take off, or to set this spread at half—on half $l00 million. I just don't think you want to go long...into the number on the full position...when you start to look at real numbers...l0%...on $200 million bucks is $20 million a year for five years.

"Yep,” said Parker.

"That's a lot of money.”

But Hudson's words of caution (though ambiguously expressed) went unheeded. On March 3, P&G decided to do nothing. "I would just as soon get the hell out of the damn thing and lose the money and leave and don't worry about it,” Parker admitted, "but the decision has been made to wait...If rates go up 25 basis points, this thing could have a negative $300 million...it could screw our earnings. I guess we're just going to have to pray that by May 19 it's down.”

On March 3, P&G's capital-markets team met with treasurer Mains. With the 5/30 down $l20 million, they decided to inform CFO Nelson. But Nelson did not notify CEO Edwin Artzt, or the P&G board, of the loss for nearly a month.

The same day, Parker got wind of a Wall Street rumor that BT had made about $l0 million-$12 million on the 5/30. "Truly beyond ludicrous,” Hudson scoffed, when Parker called him to check it out. Later, in a call to P&G treasury, Hudson fretted about the leak, making much of the fact that the "very important issue to us is the trust we built over the last couple of years,” adding, "this relationship is very important to us and I want to do everything I can to keep things going as best we can.”

His words apparently had a soothing effect. He told Bernhard later, after excoriating the "motherf***er” in the bank he blamed for the leak, that Parker called back to apologize and asked Hudson not to be so upset. Surely this was not an easy call for him to make. Parker must have realized that Hudson had no right to a posture of moral righteousness.

On March 10, P&G gave proof at last that its treasury wasn't brain-dead. It gave an order to unwind $50 million of the 5/30, which got done at CP+1055. On March 11, Hudson called Carl Slater, assistant treasurer, and offered to take an order for another tear-up "where you all would be comfortable getting out.”

"I think we're just gonna be a little patient here,” Slater said, explaining that while the company is "plenty frightened of the market,” it also felt that "it's highly irrational and way overdone at these levels.”

"We have been saying that for the last 30 basis points and that's the only reason we take pause when we try to explain away the irrationality,” said Hudson, strongly hinting that this was no time to argue with the market.

Seven days later, P&G still failed to react. Slater's response to another unwind suggestion from Hudson was, "I don't think we want to do anything. We just have to gut it through. It's kind of overbaked—overdone. Not much news.”

Final reckoning

Meanwhile, Parker asked Hudson for close-out values for the next eight weeks, assuming rates remained flat. Hudson agreed to provide the information and offered to fly to Cincinnati with a pricing model, saying he didn't want a "mysterious aura about” its position. P&G declined the offer.

Throughout the deal, P&G demonstrated a curious mix of savvy sophistication and bumbling ineptness. In one conversation, Parker admitted to one of the bankers that he had not understood risk "as we started the whole thing.” More surprising, perhaps, at this stage Parker's superior, Slater, seemed unable to absorb the crucial and painful fact that the excess spread loss had a five-year, not a one-year, multiplier. Upon being informed of Slater's mental block, BT Securities staffers talked of beating "the f***ing shit out of the piece of shit” to set him straight.

The second unwind for $50 million got done on March 14 at CP+1198 and a third, for $100 million, on March 29 at CP+1697. On April 4, P&G's mark on the DM swap was $54 million; by April 11 the deal got unwound, and P&G subsequently made a public announcement of losses totaling $195 million from the two BT Securities-engineered swaps. Hudson called Bernhard with the news, adding that he'd been told that the bank would be sued. Bankers Trust, he told her, would counter with a press release that said it "acted in, you know, the highest standards of professionalism and all this other sort of crap.”

Kevin Disses P&G CEO
In the fragmented evidence released to date, Kevin Hudson makes one final cameo appearance, in a deposition dated May 18, 1994, where he describes a second face-to-face meeting with P&G's top management to resolve their different perspectives on these swap losses, which P&G was refusing to pay.

At this meeting, the bankers provided P&G CEO Edwin Artzt with a binder of information and brief chronology, because they suspected that he had not been getting a full account of the deal from his subordinates. And the events of this encounter show that Artzt had indeed not been well-briefed.

"We explained to him why we felt we'd done a very, very good job—not only in structuring transactions that made sense at the time, but by recommending and helping them get out of there when their view turned out to be wrong. We stated that we had been virtually begging them since CP+450 to consider reducing the risk, which translated into $35 million. At which point Ed Artzt went berserk and said ‘What do you mean $35 million? I thought we lost $100 million?' And he turned to Erik Nelson and said ‘Why didn't we get out at $35 million?' At which point Erik Nelson turned ghastly white and pulled him out of the room.”

"While they were out,” Hudson told the deposition taker, "Dane Parker spoke up and stated that ‘We didn't know at CP+450. We knew at CP+200.'”

"How did the others in the room react?” he was asked.

"They almost killed Dane. He was basically told to shut his mouth.”

"Ed Artzt came back into the meeting and said, ‘Okay I'll take $35 million up—that's mine. But up to $35 million, you've got to pay part of that.' Because in this transaction, you know, he was trying to implicate us with regards to fiduciary responsibilities, ‘You have an obligation to Procter and Gamble.' He expressed his opinion that it was our responsibility only to bring them good transactions. It was not clear that he was at all aware of the transactions where they had made money with us. And this, I guess, sort of berating tone continued for a while. At which point we concluded that this was not going to go any further than the first meeting had really gone.”

What did the bank say in its defense? This was the question the deposition taker asked next. "Did Bankers Trust say at any point ‘We provided you with the sensitivity analysis?'”

"Absolutely,” Kevin replied. "Actually, you raised a good point. They kept trying to fall back on the fact that all senior management had been provided in their disclosure process after the fact was this table on the October 24 exhibit. And we said ‘What do you mean all we provided you was that?'”