In mid October, the Mexican central bank was forced to auction over $8 billion of dollar-denominated debt. The market immediately took the action as an intervention to shore up the peso. That didn’t even tell half of the story.
The action was prompted by the collapse of Mexican grocery chain Comercial Mexicana. It had, according to central bank governor Guillermo Ortiz, been acting like a hedge fund, trading volatility options with international investment banks. The central bank had been forced to intervene to facilitate an orderly unwind of the trades.
Unfortunately this was not an isolated incident. Latin American corporates took a one-way bet on the appreciation of their currencies against the dollar, and their treasuries thought it was a way of making easy money. Tell that to the shareholders of Brazilian companies Votorantim and Aracruz, which have each written off around $1 billion in FX derivative-related losses.
And don’t for one second think the problems are confined to Latin America. A week after the Mexican intervention, Chinese conglomerate Citic Pacific announced that it had suffered mark-to-market losses of $1.9 billion on leveraged foreign exchange trades – a sum substantially more than its net profit in 2007. Worse still, the company claimed one of its senior finance officials had conducted these trades without approval – and that the positions had only just been spotted. It’s clearly not just banks that need to look at their oversight of risk management.
Not that banks are immune from all this. At the end of October, Kuwait’s authorities suspended trading in its second largest bank, Gulf Bank, after it revealed estimated losses of $800 million in derivatives trades, caused by the fall in the euro against the dollar.
How big could the problem be? Given the breadth of the losses revealed so far, there must be a concern that it is endemic. In Brazil, regulators have given companies up to November 14 to reveal their positions. They estimate up to 200 companies could be affected. FX dealers say the losses have also hit a number of companies in India, although so far the size of the out-of-the-money positions is relatively small.
Perhaps of greatest concern is that the trades that companies have been losing money on are relatively simple. Most are, apparently, simple knock-out options – generally used as a low-cost way of hedging against adverse currency movements. The problem with knock-outs is, if currencies move beyond a pre-set limit, then losses can spiral.
With no sign of the end of the dollar’s recent rally in sight, more such losses seem inevitable. It’s no wonder that one senior bank managing director working in foreign exchange told Euromoney recently: "I am starting to worry that foreign exchange could be the new sub-prime." The link is strong; at its heart, foreign exchange is the largest credit market in the world, because trades are carried out through the provision of credit.
Questions will of course be asked of the treasury officials that took on such positions. But fingers will also be pointed at banks that engaged with them and sold them the contracts. As Ortiz says in an interview with Euromoneythis month: "There is an issue of ethics on the part of the investment banks that acted as counterparties in these trades with a company that had no business in this type of product or operation."
Those arguments, and maybe lawsuits, can wait. For now, shut your eyes and hope the problem is not as widespread as many in the market now fear.