The game in those pits is derivatives, those highly mathematical financial instruments that few people understand but many insist are dangerous. For corporate financial officers, the universe of ““quantos,’’ ““swaptions’’ and ““principal-only strips’’ has long since ceased to be exotic. But to politicians and reporters whose knowledge of finance ends with stocks and bonds, derivatives, seemingly created out of nothing by mathematicians wielding incomprehensible models, are the next savings and loan crisis in the making. Two widely publicized lawsuits against Bankers Trust, one of America’s most eminent banks, are fanning the flames – and stoking political pressure for regulations that could cripple the business. Says one regulator who fears the rapidly rising heat could bring counterproductive rules, ““It’s a very dangerous issue.''
Bankers Trust is the seventh largest banking company in America, but it’s nothing like your hometown bank – no car loans, no credit cards, not even a teller window. Derivatives account for a huge chunk of its business. These instruments, customized to the needs of corporate customers, come in a thousand varieties. One might entitle a truck line to buy a million gallons of diesel fuel at $1 only if the prime rate goes above 8 percent. Another might pay off if the difference between a Swedish interest rate and a French interest rate widens. Some users, such as the trucker, are hedging against risks that could devastate their businesses. Others are simply speculating. Creating such products is so lucrative that Bankers Trust has been twice as profitable as the average U.S. bank in the 1990s.
Until last February derivatives thrived in obscurity. But when the Federal Reserve boosted interest rates and sent the bond market reeling, interest-sensitive derivatives were hit hard, too. Mutual funds that had profited from mortgage derivatives for years suddenly had losses to show, as did some money-market funds – which weren’t supposed to hold derivatives at all. In the weeks that followed, a score of well-known companies, from Air Products & Chemicals to Gibson Greetings and Procter & Gamble, announced that they, too, had lost money. Most accepted their losses as an expensive lesson in financial management. Gibson and P&G did not. They pointed fingers at Bankers Trust.
In September Gibson sued for $73 million, charging that Bankers Trust gave it false information and failed to disclose the risks of the derivatives it sold. P&G followed on Oct. 27, accusing the bank of fraud and deceptive sales techniques. The SEC is reportedly looking at Bankers Trust’s sales practices, too, although neither the SEC nor the bank will comment. The suits and the rumored investigation have left Wall Street cowering. ““The rest of the industry seems to be perfectly content to support BT in private: “Go take that hill, I’ll be right behind you’,’’ says Raphael Soifer, a banking analyst at Brown Brothers Harriman.
But is Bankers Trust the culprit – or is it the fall guy? Gibson declined to discuss the case, but its lawsuit depicts it as an innocent with ““little history or expertise in derivatives and no capacity independently to evaluate the benefits or risks involved.’’ Bankers Trust, the suit claims, had a responsibility to make sure Gibson, a company with $546 million in annual sales, bought the right products. P&G, a far larger company, is a heavy user of derivatives. According to its lawsuit, Bankers Trust promised that a $200 million adjustable-rate derivative could be converted to a low fixed rate – the same idea as converting an adjustable mortgage to a fixed mortgage – but then refused to let it lock in the promised rate. Because it couldn’t fix the rate, P&G claims, it lost $102 million when rates rose. ““This is really about selling practices,’’ says spokesman Greg Rossiter.
Derivatives experts snicker at the notion that Gibson and P&G were taken for a ride. ““I don’t think you should get involved in a financial instrument if you don’t have the ability to understand it,’’ says New York consultant Tanya Beder. The two lawsuits, however, may have less to do with how derivatives are sold than with how they’re accounted for. According to accounting rules, changes in a derivative’s value don’t need to be disclosed if the derivative is being used as a hedge. If it is being held for speculation, however, a drop in its market value must show up as a loss on the owner’s quarterly financial statements. Sources tell Newsweek that the auditors for both Gibson and P&G insisted that the companies reclassify the disputed swaps from hedges to speculations, thus forcing the humiliating public disclosure of losses – which led P&G to dismiss a key executive and both companies to seek other scapegoats. P&G will not say whether the $200 million swap was reclassified, although Rossiter says it ““was intended to be a hedge.’’ Gibson states in its suit that it wanted to use hedge accounting but that the derivatives Bankers Trust sold it didn’t qualify. In the ultimate sign of displeasure, Gibson dismissed Arthur Andersen & Co., the auditors who had forced it to disclose its problems.
Had auditors not forced the two manufacturers to admit to their money-losing investments, derivatives might not be grabbing headlines this fall. But now, the publicity may force Washington’s hand. Some likely steps, such as a crackdown on money-market funds that improperly held derivatives, are all to the good. But if political pressure forces regulators to treat derivatives as securities, just like stocks and bonds, an innovative industry may be crippled or forced offshore. The companies that buy derivatives don’t seem to want it that way. Despite the controversy – and the hysteria – Bankers Trust’s profits from selling derivatives to corporate clients are well on their way to a record.
