Confessions of Chinese Derivatives Deals Part 2

(Caijing.com.cn) My understanding of what's wrong with the banking system was clarified recently when I helped a Chinese company extricate itself from a bad deal. I'm an American lawyer who spent several years working in Hong Kong for major investment banks. In that capacity, I read correspondence between the company and its bank. I realized that the system's problems are not just about greedy salespeople, but that investment banks have quite often failed as institutions. My job was to write complicated derivatives often sold to Chinese companies. Today, many companies still don't understand how risky those products are. I fear derivatives contracts could cost these companies a lot of money before they expire. Like the American government, banks have different branches that are supposed to limit the powers of one another. On one side are salespeople and traders. The amount of money they earn depends on how much they generate for the bank. So it's in their interest to sell as many financial products as possible; the more complex and profitable, the better.

On the other side are the overseers -- lawyers, credit analysts and compliance officers. Their job is to protect the firm. An overseer is supposed to block reckless transactions at any bank known for selling dangerous products that could hurt its business. My position was somewhere in the middle: I was a "legal structurer," which means I was a banker with legal training, and I was often enlisted by salespeople to get derivatives approved. I learned the process from the inside. Right around the time banks started selling complicated derivatives in China about five years ago, the financial industry underwent a change that broke down the internal balance of power at banks. Bankers who earned simple fees by helping clients raise capital began working together with other bankers who sold derivatives. The 1999 repeal of the Glass-Steagall Act in the United States and similar liberalization worldwide let banks combine the two groups of bank services under one roof. But previously they had been kept separate – for good reason. This change is easy to understand with an example. Imagine a successful, newly listed Chinese company that needs capital to grow. Its bank first gauges interest among global investors. Let's say the bank decides the company could most efficiently raise money by selling corporate bonds in U.S. dollars. But the company, which earns revenue in yuan, would face the risk of changing currency values that could make debt repayments more difficult. So the bank might propose a hedge to remove this risk from the client, in exchange for some initial profits from the derivative.

All that seems normal; it's just packaging a bond with a hedge. But think about what happened behind the scenes. The arrangers of bonds and the sellers of derivatives got together to concoct a single solution. Even though these two types of bankers are generally allowed to work at the same firm, lawyers and compliance officers would still maintain a clear separation -- the so-called "Chinese wall" -- between them. Why? To prevent insider trading. Traditional bankers who arrange bonds are considered trusted advisers and hold private information about their clients. When derivative salespeople know what bond advisers know, they may be tempted to pursue unfair profits by using information about those clients to their advantage. Bank overseers were well aware of this danger. So they made sure that any salesperson with inside company information could not trade securities in that company, nor could he or she even speak about the company with anyone from the derivatives side of the aisle. Nevertheless, derivatives bankers designed products together with bond arrangers. The potential profits were too attractive not to. And derivatives bankers always had incentives to sell clients these transactions, whether or not bond arrangers thought companies needed them. I no longer work for investment banks, and I recently advised a Chinese manufacturer that was served by a single team of bankers, which included bond arrangers and derivatives experts. The client never knew that these two groups had different motives. Worse, the company signed an agreement that effectively locked it into working with the same bank for both its debt offering and any derivatives. Even after the debt offering fell apart in the global credit meltdown, the company still wound up with a currency swap that now threatens to wipe out its quarterly profits. Clients may have known about these conflicting roles, but such awareness would not have come easily. Contracts were complicated. See if you understand this contract language: The bank "may effect other transactions involving financial instruments related to the bond offering and other transactions contemplated herein." That means the bank might make money off a deal, whether or not its client does. But many Chinese companies didn't understand the implications of that kind of language, whether they read it in Chinese or English. And salespeople certainly didn't go out of their way to enlighten them. This conflict of interest has caught the attention of Chinese regulators. But the issue won't be resolved anytime soon. From now on, Chinese companies, especially those with derivatives already on their books, should watch for what really motivates their bankers.

Confessions of Chinese Derivatives Deals, Part 1

By Mushtaq Kapasi

(Caijing.com.cn) Even America's most famous investor, Warren Buffett, admits he got burned by derivatives during the global financial crisis. And if he didn't know what he was doing, imagine what could happen in the future to Chinese companies.

Many Chinese firms had little experience with complicated financial products such as derivatives before they bought billions of dollars worth of these investment products. Many of these investors, especially small to medium-sized companies, could see their profits wiped out, and may face bankruptcy if their investments explode.

Why do I think this? Because I helped create these derivatives. I'm an American from Texas who worked for about a decade for international banks and law firms. Derivatives experts sought me out because I'm a lawyer with a degree in mathematics. I spent thousands of hours in Hong Kong skyscrapers translating the calculations and cash flows into arcane, legal English. And I eventually figured out how the banks -- and, I must admit, myself -- could profit by selling products their customers didn't fully understand. T

The basic concept behind derivatives is simple. They are financial agreements in which one party agrees to pay another party if a market goes up or down. For example, imagine an airline that buys jet fuel. The airline could face trouble if the price of oil shoots up. To protect itself, the airline can buy a derivative -- a hedge -- that will pay money if the price of oil rises. Of course, if the price of oil drops, then the airline would lose money on its hedge. But, on the other hand, it would also pay less for fuel. You could think of this sort of derivative as a type of insurance.

But in China, the profit margins on simple and safe derivatives fell too far for foreign banks. A couple of years ago, after they sold all the derivatives they could to large Chinese banks and state-owned enterprises, investment banks then targeted smaller Chinese firms. These firms had less money, so the only way for the banks to maintain their profit levels was to make derivatives more complex and risky. My job was to write them.

Many small Chinese companies had taken out loans and wanted to protect themselves against changes in interest rates. A simple hedge would have worked fine. Instead, the banks sold complex derivatives called "cost reduction swaps" that were linked to such obscure factors as differences in euro interest rates. When the credit crunch hit Europe, Chinese clients suddenly had to pay millions of dollars to their investment bankers.

Or consider what happened last summer, when the world believed that the yuan would appreciate. Small manufacturers who earned revenue in foreign currencies worried that their yuan expenses would remain constant while the yuan values of their sales would fall. Banks were eager to help these factories hedge their currency risks, but because everybody in the world believed the yuan would appreciate, it was very expensive to hedge.

So the banks created some tricky products. One popular derivative would arrange payments every month between a bank and company. If the yuan had gone up from the start of the trade, the bank would pay the company. If the yuan had gone down, then the company would pay the bank. These monthly payments would continue for five years. But to make monthly payments more favorable for the company at the start, many banks gave themselves the right to terminate the derivatives earlier than scheduled. If the trade was hurting a bank, it could tear up the contract; if the trade was helping the bank, it could continue to profit -- and the company would have no choice but to continue losing money.

China Eastern Airlines is one notorious case of a perilous hedge. Quite sensibly, the airline bought derivatives that would pay if oil became more expensive. But to make the hedge cheaper in the short term, China Eastern agreed that if oil prices dropped past a certain point, then it would have to pay double what the bank would have to pay if the price of oil went up. After the oil bubble burst last year, the company admitted these derivatives cost them 6.2 billion yuan -- and obliterated their profits for 2008. Of course, China Eastern is a huge company with government support. Most small investors are not as lucky.

By most estimates, at least hundreds of these unnecessarily complicated derivatives remain on the books at Chinese companies. Many are linked to markets that could go haywire at any time. Chinese derivative holders would then face enormous costs that many can't afford. I would urge all companies that bought derivatives to pull the contracts from their files and read the fine print now. No one forced companies to buy these derivatives or accept the contracts the banks wrote. But the banks always knew so much more than the companies, and they exploited this advantage. In the end, I decided to leave on my own, to try to make the game fairer and bring derivatives back to their intended purpose. In a future article, I will explain how structural incentives in banks actually encouraged derivatives that were not right for clients. Derivatives in China didn't have to turn out this way.

Mushtaq Kapasi is president of Octagon Pacific, a structured finance consultancy.