EXOTIC DERIVATIVES HAVE had a bad 12 months. They have been branded the evil product behind the global recession, while the banks that created them have paid a heavy price for their use. In Mexico and Brazil some corporates used exotic currency derivatives to bolster their balance sheets. Now the regulators, bankers and corporates are sorting through the damage hoping to develop solutions that will make this a one-off problem.
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“The exporters started selling multiples of their FX revenues. Why on earth would anyone do that? It’s the equivalent of saying: ‘We’re an exporter and our margins are shrinking because the real is strengthening. How about we take some of our working capital to Las Vegas to see if we can boost our margins?’” Arminio Fraga, BM&F Bovespa |
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At first sight it appears the Mexicans and Brazilians are facing the same issues that financial markets worldwide are struggling with: should all derivatives be regulated with daily marking to market on exchanges, or would this limit flexibility and financial innovation?
Although this is certainly part of the discussion, there is another issue. Unlike in the US and UK, in Latin America it is corporates that suffered the biggest losses, not the banks. It seems that not only was regulation not in place, but even those regulations and documentation practices that were established were disregarded by some banks in their rush to claim market share. In turn the corporates, which were initially making good money out of these FX derivatives contracts, were inclined to keep the banks in the dark about their exposure levels and number of counterparties.
In Brazil total losses were estimated at $25 billion, with public companies Sadia, a poultry processor, and Aracruz, a paper and pulp manufacturer, leading the way with losses of R$760 million ($413 million) and R$1.95 billion respectively. In Mexico losses reached up to $15 billion and household names such as Comercial Mexicana, a supermarket chain best known as Comerci, and Gruma, a tortilla wheat-flour producer, nearly collapsed.
It wasn’t only the corporates that lost out. The bank counterparties also suffered, and those that were most active – including Merrill Lynch, Deutsche Bank, Credit Suisse, JPMorgan and Goldman Sachs – have struggled through the legacy of these deals for nearly a year.
Quick and pain-free
Immediately after the corporates in each country admitted to their losses, it quickly became obvious that the bank counterparties were going to suffer too. “The problem is, maybe some of these institutions had a balanced book, with being a net seller of options on one side and a net buyer on the other,” says Javier Duclaud, director of operations at Mexico’s central bank. “If you looked at their position it was zero; but their credit position was not necessarily zero. If you get a bad enough event and one of the counterparties cannot honour its obligation and you have no way of collecting owed money, then suddenly you really aren’t balanced at all.”
As losses were disclosed some corporates closed their positions fast, enabling the bank to close its positions too and the corporates to organize quick repayment deals for the losses they had taken.
Mexican corporates such as industrial conglomerate Alfa and construction group ICA fell into this camp. For ICA a deal was struck with Merrill Lynch relatively quickly and quietly. An ICA company report states: “On April 24 2009, we reached agreement with our financial provider to completely restructure the derivative instruments into a new one. The aggregate notional amount was reduced and the flows were reprogrammed in accordance with an updated schedule for construction and project disbursements. In addition, any asymmetrical conditions were eliminated and the reference exchange rate was increased. The fair value of the restructured derivative was Ps466.47 million [$36.2 million] as of April 24 2009.” Following this, ICA successfully reopened the Mexican equity markets with a Ps2.3 billion follow-on in July – the country’s first equity offering since June 2008. Bank of America Merrill Lynch was lead bookrunner.
But these quick deals were in the minority. After Comerci defaulted on its debt, the real extent of the problem started to emerge. Within hours of Comerci’s announcement several banks, with Merrill Lynch at the helm, opened discussions with the central bank of Mexico. Governor Guillermo Ortiz realized Comerci was not alone: the banks knew the volumes they had each done and now, assuming competitors had reached similar levels, it was suddenly clear that the problem wasn’t going to go away quickly. It also became clear that corporates, including Comerci, had neglected to tell their banking counterparties just how many banks they were dealing with – the banks involved had had no idea until this point just how exposed the corporates were.
Aggressive selling
Following group discussions in mid-October, Ortiz and Guillermo Babatz, president of Mexico’s regulatory body, the Comisión Nacional Bancaria y de Valores (CNBV), decided to conduct individual interviews with each of the banks. These meetings not only revealed how deep the problem was and how exposed certain corporates were, it also highlighted the fact that certain banks had taken a lax approach to International Swaps and Derivatives Association (Isda) documentation and Credit Support Annex (CSA) documentation.
“I did a hedge and the bank didn’t request a CSA agreement that would make them able to call margin calls,” says Gabriel De la Concha Guerrero, chief investment officer at ICA. “The bank was very aggressive – it was the way of getting the contract with us but it didn’t give them many claw-back features. The banks aren’t going to do that again and I guess that is best for both parties. When everyone understands what they are getting into then things will be much better. The companies and banks are going to be more disciplined now.”
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“If you looked at their position it was zero; but their credit position was not necessarily zero. If you get a bad enough event and one of the counterparties cannot honour its obligation and you have no way of collecting owed money, then suddenly you really aren’t balanced at all” Javier Duclaud, Banco de México |
The central bank’s Duclaud says: “The investment banks were collecting fees out of these transactions and so, as the derivatives market became very competitive, many banks, in an effort to get market participation, neglected certain things. These derivative trades should have been backed by Isda contracts with collateral agreements in place – the CSAs – but many of these transactions were not backed by these documents. It was stupid of the investment banks. Everyone failed to recognize that there was a big credit risk involved in these transactions.” Without the CSAs the banks involved, among them Credit Suisse and Deutsche Bank, were in a weak position, facing the risk of mounting losses. Both banks declined to comment to Euromoney. Apparently Merrill Lynch, even though it had a lot of exposure to these exotic derivatives, had fully signed CSAs across the board.
“It was amazing to us that a lot of the banks hadn’t signed CSAs,” says the CNBV’s Babatz. “This meant that some of the corporates didn’t have to post margin calls, which gave them a lot of bargaining power with the banks. The banks were in a terribly tricky position. If the banks closed the position and then the currency did rise again, the corporate could close the contract at the new level, leaving the bank with a loss. If the currency depreciated further and the bank left the position open in line with the corporate, then it was abundantly obvious that the corporate would then not be able to pay – the bank loses again.”
Gruma had this ultimate bargaining chip. Apparently several of the banks that sold contracts to Gruma did not enforce CSA documentation. Eventually the banks closed their positions and with what bargaining tools they had opened discussions to find a middle ground to cover the losses made. This helps explain why Gruma’s deal has taken so long – on March 23 the firm finally ended all its foreign exchange derivative instruments with Credit Suisse, Deutsche Bank and JPMorgan Chase. By late August it looked as if Gruma had converted its $726.6 million of losses into term loans with its counterparties. The facility is likely to have a 7.5-year tenor at Libor plus 2.875% for the first three years. In Gruma’s second-quarter results the group states: “In order to minimize the counterparty solvency risk, the company enters into financial derivative instruments only with major national and international financial institutions using standard International Swaps and Derivatives Association forms and agreements.”
It’s a blame game
As losses mounted certain corporates, with and without CSAs, tried to shift the blame. The corporates and financial officers blamed the banks for their own misdemeanours in the derivatives markets.
“From what we hear from the companies, there were a couple of investment banks out there that were very aggressively selling FX derivatives as a way of reducing the cost of debt without much risk, but this was assuming the real or peso stayed in a tight range,” says Will Landers, senior portfolio manager at BlackRock. “At the time it didn’t seem like such a tight range but then the exchange rates blew out. No doubt these FX instruments probably helped the currencies to overshoot as well.”
Rob Rauch, director of research at Gramercy, a distressed emerging markets debt-focused fund management group, heard similar lines of defence from the corporates: “The CFOs remind me of Procter & Gamble’s derivatives losses in 1994 when they disingenuously claimed they were just naive country bumpkins taken advantage of by the Wall Street bankers – but this time I think there is an element of truth.”
There were also murmurs that the banks in Brazil that had made a healthy profit from the IPO boom were desperately looking for new markets to bolster the bonus pot – exotic derivatives presented the perfect opportunity.
For international banks that had been granted a separate bonus pot from the rest of their global organization, this drive was yet more intense, resulting in risky trades taking place that senior management in the banks’ foreign headquarters apparently had not authorized.
But the banks responded quickly to this initial backlash, pointing out that these trades had been going on for years: while balance sheets were bolstered and returns on equity were high, everyone was happy.
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“I did a hedge and the bank didn’t request a CSA agreement that would make them able to call margin calls. The banks aren’t going to do that again and I guess that is best for both parties” Gabriel De la Concha Guerrero, ICA |
“The Mexican corporates made money in the past five to six years from these derivative trades. As a result they became very comfortable with them,” says a senior banker involved in the business. “The corporates had a process for doing these trades, and the banks had risk guys explaining both sides of the trade to them. I think the corporates were very much aware of the risks but they didn’t expect the extreme shock of cumulative derivatives all reacting in the same manner.” ICA’s Guerrero says: “Companies need to be more disciplined and not rely on the government being the father, saying what we can and can’t do. We are mature companies and therefore should take responsibility for the things we do. There is a need to revise the incentives in the company so shareholders are protected and short-term financial incentives are aligned with the company’s long-term welfare.”
A senior banker notes how corporates had come to banks asking for these products. As the banks gradually cleared their names in Mexico so the shareholders turned on the CFOs. In turn the CFOs were quick to note that other members of senior management at the companies were involved. “The CEOs had to sign off trades before the CFOs could execute any derivatives contracts. More senior management than just the CFO knew what was going on,” says one CFO who was reluctant to allow his name to be used.
Investigations and prosecutions
The Mexican regulators are now searching through eight of the worst-affected companies trying to work out if they were in violation of the markets law. “We need to see whether or not they have done anything prohibited regarding the securities market law,” says Babatz. “The issue is whether or not they informed the public in a timely manner and, second, once the risk materialized, if they disclosed to the public in the right manner at the right time. These investigations are ongoing.” Babatz is nearly finished with three companies.
“Outcomes will vary,” says Babatz. “In the worst-case scenario there will be criminal charges and hefty fines. The law says that a company has to reveal any relevant information as soon as that information is known to the company – clearly these derivatives and their risks are very relevant, so we need to decide whether the information was withheld with intent or not. We cannot disclose details until the fines are paid or legal battles completed.
“These investigations are very important. They are the first important event that we are investigating under the new securities market law and so we have to prove that the law does work.”
Yet investors remain sceptical. Gramercy’s Rauch is wary of taking on distressed debt in Mexico because there are still many weaknesses that require more work.
When Credit Suisse was advising Comerci initially, the Mexican group tried to file for bankruptcy. “This was the worst thing Comerci could do because the bankruptcy law in Mexico says that if you don’t get a resolution in a certain length of time then you have to sell the assets. It’s a timetable to liquidate your assets,” says Roberto Charvel, founder and chief executive of Vander, an investment management firm in Mexico. “It’s like putting a gun to your head. You don’t get bankruptcy protection here like in the US.”
As creditors continue discussions with Comerci, which is now being advised by Rothschild, it seems that even though the solution has been dragged out, the situation will be resolved in the coming weeks. “Rothschild is very good at playing the good cop, bad cop role,” says a creditor involved in the talks.
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Brazil has also started investigations into Aracruz and Sadia. After losses were announced both companies were rapidly mopped up by industry rivals in merger deals in which development bank BNDES and the government played prominent roles. Now the individuals involved, who have already lost their jobs, and the companies are set to face further punishment. “We have opened investigations and then once we have all the information we will decide what to do with them,” says Marcos Pinto, commissioner at the Comissão de Valores Mobiliários or CVM, the securities regulator. “If people conclude that the managers were negligent, then the commission will issue an accusation and the accused responds. Finally the commissioners, I and my colleagues, will decide the case. Both CFOs have already lost their jobs and been penalized by the market but we still need to find out who else was involved.” Aracruz shareholders are now suing the former Aracruz CFO, Isaac Zagury. However he has publicly stated that a financial committee that included representatives for each controlling shareholder oversaw all derivatives operations at Aracruz. He estimates that another 400 companies undertook similar currency bets and have not declared them.
By contrast, in Mexico, some CFOs have kept their jobs. One banker is philosophical about this: “When you have a family-controlled business this kind of thing takes place.” It is these family ties and strong family groups that make some investors wary of how effective new regulation will actually be.
Mexican migration
Just days after Comerci’s default in October, the Mexican authorities introduced new, more detailed guidelines for corporate disclosures. They also specified that disclosures should be made quarterly, not annually.
No further measures are expected from the CNBV, the Mexican regulator. However, as in the US, the authorities are also looking at ways to encourage more trades to be undertaken on exchanges or through clearing houses, rather than over the counter. In Mexico the OTC market accounts for roughly 70% of all derivative trades.
Details are still not finalized but the Mexican authorities are pushing for change in the OTC market.
“Banks will need to take higher reserves when trading OTC and will need to comply with strict requirements set by the regulators,” says Jorge Alegria, chief executive of MexDer, the leading Mexican derivatives exchange. “This will be an incentive for banks to move away from OTC trades where possible.
“The banks may not love this idea, as OTC gives them more room to structure complicated stuff and make more money. Margins for the banks are smaller on an exchange, but OTC trades will be more expensive once these trades require more credit lines to cover them. The Mexican authorities aren’t going to ban OTC – they are just making sure the risk associated with OTC trades is accurately reflected on the balance sheets of the banks.”
Even these measures are a concern to some bankers.
“Pushing all derivative contracts on to exchanges is not ideal,” says a senior banker in New York. “Some corporates need tailored solutions, which are flexible. The problem with listed products is that they are all customary and regulated and can’t be unique. There’s still very much a place for OTC derivatives today.”
Another possible solution is to use clearing houses. This is being discussed in the US, and the Mexican authorities are keeping a close eye on progress.
“We are looking at what the rest of the countries are doing,” says Babatz. “Before we decide the best route, we are going to see where the dust settles in the US or UK and then decide which road to go down.”
Brazil is facing a different challenge. Already, all local OTC trades have to go through Cetip, the local clearing house. Brazil also controls risk incurred by the final customer, whereas most other countries stop at the broker level. “Seeing through to the final customer is a powerful tool,” says Carlos Kawall, chief financial officer at BM&F Bovespa. “We have an account for each investor and the collateral is placed in this account. In other markets collateral is posted with the broker and this was a problem during the Lehman crisis.”
Brazil’s regulation already goes further than that in the US and UK. “Maybe the US and UK could learn a thing or two if they looked a little closer at certain aspects of Brazil’s derivatives regulatory environment,” says a market source in New York. Another says: “Brazil’s regulatory environment is restrictive. Having everything listed with a clearing house with access to end customers is time-consuming and unnecessary.”
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“Nearly all the derivative issues our corporates suffered from last year were OTC trades that were booked offshore so we couldn’t trace them at all. I think the Brazilian legal system is in good shape but we need to open discussions on the international level” Henrique Meirelles, Banco Central do Brasil |
Despite these measures and a push towards using an exchange or clearing house, Brazil didn’t prevent its corporates suffering losses. “Nearly all the derivative issues our corporates suffered from last year were OTC trades that were booked offshore so we couldn’t trace them at all,” says Henrique Meirelles, Brazil’s central bank governor. “I think the Brazilian legal system is in good shape but we need to open discussions on the international level. The whole subject goes beyond derivatives and into the field of cross-border operations. That is the kind of thing that is being analysed and is important for financial market stability in the future. We have to develop a way to share information so everyone is better informed.” The BM&F exchange in Brazil is now linked with the Chicago Mercantile Exchange. Kawall hopes that as pending regulations are finalized, a stronger relationship will help some offshore trades be rerouted into the local market.
The CVM already requires corporates to disclose all their derivative positions quarterly and run simulations of how these positions would be affected in good, bad and medium-case circumstances. This will be in addition to providing extra information before extraordinary meetings, including manager remuneration, conflicts of interest details, a discussion and analysis of financial statements and related-party transactions. The details of this disclosure annex will be finalized next year.
Another tool that the CVM hopes will be up and running by early 2010 is a derivatives database. After a specified time period, say each month, every bank will have to report its derivative exposures to the central bank in Brazil. The data will be collated into a database and released to all Brazilian banks. There is a hope that this would alert the authorities if volumes in one particular contract were to shoot up.
Mark-to-market mania
An oft-touted solution to derivatives risk is to enforce mark-to-market clauses in all trades – on exchanges and OTC. But there are fears that marking to market across all derivatives products could hinder development and put undue pressure on the financial system.
In late 2008, Brazil’s problems were exacerbated by the financial markets suffering from a sharp decline in liquidity. Credit dried up, foreign investors repatriated money by selling reais, the currency dropped more than 35% in a matter of weeks and yet all derivative contracts on the BM&F exchange were still subject to daily mark-to-market regulation.
“In September we expected to meet some bumps – we were at the end of an amazing run. However the downturn was sudden – as credit was lost and positions had to be liquidated, the market ended up spiking the other way,” says Fraga. “When it became clear we were in for a real rough environment, all the risk systems kicked in. The exchange increased its initial margin and kept on doing the daily mark to market for every position with matching payments. This drained a lot of liquidity from the system as quite a bit of money went to the exchange to support the positions. Gradually the system was squeezed even more, the currency dropped even further and the potential losses on these complex OTC FX contracts carried on growing.”
MexDer’s Alegria also acknowledges this. “I guess in Mexico, at the peak of the crisis in October last year and early this year, the mark to market put even more pressure on the system.” However, despite the daily mark to market’s negative drag on liquidity, Fraga and Alegria still insist that it was, and is, a crucial practice for the exchanges. “The first loss is the cheapest one,” says Alegria. But corporates are reluctant to agree.
Some hedges require the underlying asset and the derivatives contract to converge when they reach maturity. However, if a mark to market is enforced on one leg of a transaction during a one-off movement that is just beyond the threshold, the corporate will have to pay the price of organizing new hedging contracts. Other corporates say they have longer-term FX flows and argue that they aren’t running the risk in the short term – they are exporters and the money will come in two to five years, so positions need to be open and flexible over the longer term.
Again the lack of flexibility on the exchanges is a problem – exchanges have standardized daily mark-to-market requirements whereas the OTC markets have room to be more accommodating to individual needs.
However, despite the corporates’ concerns, there is a fresh push towards new mark-to-market contracts on all trades, including OTC deals.
Duclaud of Mexico’s central bank makes his stance clear. “We certainly favour daily mark to market in the OTC arena and that is what we will encourage,” he says. “Our regulations on repos, for example, require banks to have contracts where margins are clearly defined. But we are not the ones saying at exactly what levels these mark-to-market provisions should be activated for each product. We just want mark to market to be established as a common practice with clear contracts – the details can be agreed between the client and the bank involved in the OTC trade.”
As the debate continues, one side saying Brazil has too much regulation, the other saying Mexicans have too little and that what they do have is flagrantly disregarded by many in the market, it is clear that investors and international regulators will play a role in how these discussions come to a conclusion.
The challenge will be to find common ground where disclosure and documentation standards are sufficiently high for counterparties but low enough to avoid other balance sheet risks for the corporates. Today Brazil and Mexico are just at the start of finding that balance. It will take time to get it right.
