Commodities and Derivatives: Risky world of leveraged swaps

JUST as arch-speculator George Soros was warning US congressmen last week about the inherent dangers of securities derivatives for the financial markets, Edwin Artzt, Proctor & Gamble's chairman, stepped up to warn shareholders that the company will take a dollars 160m pre-tax hit in its first quarter earnings due to speculative losses by its treasury on esoteric and highly risky 'leveraged swaps'.

Add another victim to the growing list of corporate casualties which have seen millions blown away by the use of complex financial instruments by corporate treasury departments.

Britain has Allied-Lyons, which lost pounds 150m when its treasury made risky bets via currency options in 1991. Earlier this year Germany's Metallgsellschaft uncovered more than dollars 1bn of losses on speculative oil futures trades at its US subsidiary.

Not alerted by the massive losses on share option trading incurred by Japanese companies in the 1980s, Kashima Oil last week said it had racked up dollars 1.5bn in currency trading losses, matching those achieved by fellow oil company Showa Shell last year.

But, in a new twist, an angry Mr Artzt announced that Proctor & Gamble was 'seriously considering our legal options relative to Bankers Trust'.

A company suing its bank adviser for putting it into inappropriate derivatives trades would be ground-breaking and would send shivers around the international bank community, which has seen the global swaps business alone grow to dollars 4,500bn.

While the speculative interest rate derivatives that cost Proctor & Gamble dear are used widely in the financial markets, those who typically make such daring bets are rarely non-financial corporations.

Many companies, particularly multinationals, use derivatives to guard against big moves in interest rates, commodity prices and currency rates. But Proctor's 'leveraged swaps' were not a hedge but a bold wager on the direction of interest rates in the US and Germany.

In a typical interest rate swap transaction, one party exchanges a fixed-rate obligation for another's floating rate liability.

In Proctor's swap the company appears to have held a floating rate obligation with a 'multiplier', which meant its losses would be magnified by a significant closing of the gap between German and US interest rates, an event which occurred in the last six months.

But lawyers say Proctor's legal ground for suing its bank is shaky. 'There is virtually no precedence in the US which supports what the company is advancing,' said a lawyer at a New York firm which advises both Bankers Trust and Proctor & Gamble.

In the US there is plenty of precedent defining brokers' responsibility towards clients, an area called 'suitability'. But in trades such as those set up by Proctor & Gamble with Bankers Trust both are counterparties to a contract and the bank does not have a fiduciary responsibility.

In any case, Bankers Trust said it formally warned Proctor about the risks it was running.

To bring a suit, Proctor would have to be creative and would be looking to set a precedent. But would the courts be willing to make law in this area? In Proctor's case, as in virtually all of the publicised cases of large corporate losses on derivatives, the directors were in the dark until it was too late. Rather than making a serious threat, Mr Artzt may have been venting his frustration.

One way to guard against the risk that a bank might recommend unsuitable derivatives is to have an overarching mandate between a company and each of its banks which sets parameters for dealing with treasury staff. Neither Proctor nor Bankers Trust would say if such a mandate was in place.

But even the clearly defined mandate is only the first step for corporate boards looking to avoid nasty surprises, says Richard Raeburn, a consultant at KPMG, which advised Allied-Lyons in the wake of its 1991 losses.

''Corporations have lost money in treasury regularly and consistently over the years,' he says. 'Corporate disasters underline the need to have a proper control structure in place.'

KPMG's latest survey of corporate attitudes to treasury found that just 14 per cent viewed it as a profit centre.

However, a majority said that their treasury departments were allowed to hedge their exposures selectively rather than 100 per cent, suggesting that treasuries are expected to add value.

'In adding value they are taking risk and that brings you fairly and squarely back to the question of how do you control that risk,' says Mr Raeburn.

'It really comes back to a question of whether senior management is aware of the risks in treasury.'

The answer to that question is a resounding 'no', according to a survey on derivatives published last month by the Group of Thirty, a Washington-based study group.

The survey found only 28 per cent of directors had a good understanding of the concepts and risks of derivatives, while 65 per cent had a 'heavy reliance on the next level of management'.

That will add more fuel to calls for the regulation of the risky and little understood world of derivatives.