May 15, 2013

Derivatives Spaghetti: Procter & Gamble - Bankers' Trust. Also on OTC products.

"I've seen things in the market where I scratch my head and can't imagine why people did it. For example, when P&G lost all that money, I couldn't fathom what anyone at the company was thinking when they looked at the formula of that swap and said "Yes, that's exactly what I want to put on." - Confessions of a Structured Note Salesman.

On November 1992, Procter and Gamble (P&G) and Banker's Trust entered a five year interest rate swap contract (called '5/30'), with semiannual payments, on a $200 million notional amount. Interest Rate Swaps are the most diffused and heavily traded financial products whose notional amount outstanding corresponded to $347 trillion in 2012, according to the Bank for International Settlements (BIS). P&G wanted to reduce their annual interest expenses ($500 million) by $100 million. Companies as big as P&G are exposed to foreign exchange and interest rate risk as they operate worldwide. Compared to other derivatives disasters, P&G ended up losing only $157 million, lowering their earnings per share by 0.15 cents. Why was this such a big event if the loss was so 'small'? First of all, it was the first case of a derivatives transaction ruled by a judge (1996). Second, it raised concerns over accounting reforms for corporate disclosures (see later in the post). Third, it gave us a glance of the behind-the-scene world of investment banking.
The structure was pretty much standard although it was based on a bizarre formula. P&G paid a floating interest rate in exchange for a fixed one. P&G was short the swap. The fixed interest rate was 5.30%; the floating one was set as the following: 

30-day Commercial Paper Daily Average Rate - 75 basis points (as a premium for P&G) + a spread.

The spread was calculated according to the following formula:

The 5-year CMT is the yield on the five-year constant maturity Treasury Notes, the30-year treasury (TSY) price is the price for the 30 year T-bond maturing in August 2023. 
This contract is particular and one of its kind as it has several interesting features:

1) It does not use what is conventionally used as the standard floating rate, that is the LIBOR rate; 
2) The source of leverage is the spread;
3) It relates short term and long term interest rates (through the 30-year TSY price) in an inverse relation;
4) The spread for the first semiannual payment was set to 0;
5) The other 9 semiannual payments (out of 5 years) were fixed on the interest rates a specific date (May 4, 1994). 
The key components in the swap contract are:
- The 30-day Commercial Paper Daily Average Rate (like an Asian product), not the specific rate at a certain day;
- If the spread was 0, P&G would have paid 75 basis points minus the CP rate;
- The higher the 5-year CMT interest rate, the lower the 30-year TSY price (as the interest rate on this security goes up), the higher the spread in the formula is. 

P&G was betting on interest rates to remain stable over the next five years (that is the spread to be ~0). If so, P&G would have paid 75 basis points minus the CP rate and saved some money in interest payments (its original goal). didn't happen! In fact, the FED in February 1994 tightened its monetary policies pushing yields up:

5-year Treasury CMT moved from 5% to 6.73%. 30-year Treasury Rate moved from 6.12% to 7.40%.
Was it difficult for P&G to see how its position moved as interest rates did? NO, not at allThey could have formulated different scenarios, calculating the spread for different interest rates moves. 
Let's see this point through 2 examples:
1) Assuming a 5.02% interest rate on CP and a 6.06% yield to maturity on the 30-year Treasury bond (equivalent to a price of $102.58):
The spread in this case would be 0 as it is negative. In this example, interest rate are chosen to be low. P&G would have to pay the 30-day Commercial Paper Daily Average Rate - 75 bp.
2) Let's try now with high interest rates: assuming a 6.71% interest rate on CP and a 7.35% yield to maturity on the 30-year Treasury bond (equivalent to a price of $86.84):
The spread in this case is equivalent to 2750 basis points or 27.50%! P&G would have to pay:
30-day Commercial Paper Daily Average Rate - 75 bp + 2675 bp!

By simply using an Excel spreadsheet, Smith (1997) calculated the magnitude of the spread according to several interest rate moves. P&G could have done so, before it entered the swap contract, to have a better idea of what could have happened: 
Multiply the values by 100 to get the spread in percentage terms. For example, a 6.50% on the 30-year Treasury Yield with a 6.75% 5-year yield would have costed P&G 1830 basis points or 18.3%. 
P&G entered an over-the-counter product with Bankers' Trust. Why do firms prefer OTC products over products traded on exchanges? The benefits are mainly three: 
- Liquidity, because...
- No margin is required (when the parties enter the contract a/o for entire settlement period) and...
- Securities are not marketed to market (MTM); 
- Accounting benefits; 
P&G preferred an OTC product because of favorable accounting treatments: the transaction could have been amortized over 5 years, with deferred income and expenses. The contract itself was regarded by the accounting standards as an hedge and not as speculation (as written options are). 

It is important to understand how market participants use derivatives, which seems to be the real problem and key player in disaster. And the next question is: should corporate treasuries behave as profit centers? P&G was speculatingIn each of the three cases I specifically talked about (see here and here), the inappropriate behavior of one or more parties involved played a prominent role in the disaster. Also, the level of expertise of the parties is important as well as the supervision of the risk management systemTo conclude, investors should primarily prefer vanilla products over complicated ones. If you can't understand the structure of a product, avoid it. It may sound obvious but when we look back at these derivatives disasters "you scratch your head and can't imagine why people did it."

Donald J. Smith (1997) - Aggressive Corporate Finance: A Close Look at the Procter & Gamble-Bankers Trust Leveraged Swap


No comments:

Post a Comment