The Banks' Nuclear Secrets

By Bernard Baumohl

The instant Asia's economies cracked last year, Howard Greenspan feared the worst for his bank. As a longtime customer and investor in the Canadian Imperial Bank of Commerce, the second largest in Canada, Greenspan knew it was a big player in the Asian derivatives market. The bank would suffer from the Asian fallout, but how much? At the company's annual meeting in January, Greenspan, a Toronto management consultant, asked CIBC chairman Al Flood about the bank's derivatives. But Flood cut him off, and a subsequent attempt was unavailing. So Greenspan took CIBC to court a month later to compel the bank to talk, but he got nowhere. "Derivatives, even if played by the rules, are a deadly game," says Greenspan. "I was very concerned about my bank's exposure." CIBC isn't an isolated case. Among U.S. institutions the dollar amounts are so huge and the risks so high that bankers recoil when the topic is raised. But they may soon have to talk.

Derivatives are a kind of nuclear financial instrument. They are powerful and highly complicated agreements designed to offset certain financial risks. Under steady conditions they work well. But in derivatives, like nuclear mishaps, there are no small accidents. And as the Asian economic crisis worsens--and in Indonesia's case nears catastrophe--the financial Geiger counters are beginning to buzz.

J.P. Morgan, America's fifth largest bank, got bad news this year when several South Korean firms suddenly repudiated their derivative contracts, leaving Morgan out some $500 million. America's biggest lender, Chase Manhattan, saw its "nonperforming" assets in Asia triple in the first three months of 1998, to $243 million, due in part to derivatives. At the end of last year, its total risk from Asian derivatives--should others default--was more than $3 billion. Bankers Trust's derivatives' delinquencies have leaped from zero to $330 million in a year, and the compass points to Indonesian and Thai clients. In total, the bank has some $5 billion of derivative credit exposure in Asia. And Greenspan was quite right to be concerned about CIBC. The bank has nearly $1 billion in gross foreign derivatives with parties that are below "investment grade" (translation: risky).

And now comes the bad news. Some $10 trillion (yes, $10,000,000,000,000) in derivative contracts are set to mature this year for U.S. bankers, and the U.S. bankers are holding their collective breath to see which of their Asian clients will pay up. Many won't. "Those who believe there won't be any further derivative losses from Asia couldn't be more mistaken," says Edward Furash, a bank consultant based in Washington.

There are two types of risk associated with derivatives: market risk and credit risk. The former describes the possibility that you've bet the wrong way. These losses are theoretically limitless, another interesting feature of derivatives. The latter risk is simply that the counterparty doesn't honor the agreement.

Credit risk is the problem that American banks are facing. Buried deep within the arcane bank statements filed with the Securities and Exchange Commission is evidence of a potential chain reaction of derivatives heading toward an explosion. "I've been an analyst for almost 20 years now," says Charles Peabody, of Mitchell Securities, a brokerage firm in New York City. "Analysts like myself are learning for the first time how derivatives behave in bad times. I think we've just seen the tip of the iceberg of the problems with derivatives."

The banks say analysts such as Peabody are overplaying the danger, and, following some minor calamities in 1994, their use of derivatives follows a prudent management scheme. But according to the Treasury Department's calculations, the iceberg is huge. The 25 American banks with the largest position have more than $350 billion in credit exposure to derivatives--that's more than enough to wipe out the $250 billion in equity capital that the same banks keep on hand as a cushion to absorb losses. Few believe that Asia's troubles could jeopardize the entire amount--that would take a global, systemic collapse--but the possibility for some big hits is real. And although the losses in derivatives last year were small and manageable ($125 million), "these losses tell me that banks are taking on more risks," says Mike Brosnan, director of the treasury and market-risk division for the Office of the Comptroller of the Currency (OCC), an agency that regulates U.S. banks.

A product of sophisticated math and computer software, derivative contracts are designed to help banks, corporations and countries hedge against financial uncertainties, such as changes in interest rates. But the banks found that they could make a killing by concocting more exotic derivatives that effectively bet on the future direction of interest rates, foreign exchange, commodities and stock indexes. And since banks aren't making much money from traditional lending these days, derivatives became the highway to new revenues and profits. Accounting rules made derivatives attractive too, since the contracts didn't have to show up on bank balance sheets and thus were beyond the prying eyes of investors and analysts.

The alchemy of derivatives rests on complex mathematical models that predict how markets and derivatives will behave under certain assumptions. The computer models use past market performance to portend the future, but they can't account for the unaccountable: every once in a while an asteroid does strike or countries blow up. These things aren't fully factored in the modeling. Besides, the global economy today is radically different from just five years ago. "Banks have been going out further and further on the risk spectrum, especially the big banks," says Furash. "They are all looking for bigger returns, since they aren't getting it through lending. The danger is that the expansion is to the point where big banks are engaged in risk warfare."

The result: in just three decades, the volume of derivative contracts with U.S. commercial banks exploded, from practically zero in the early 1970s to more than $25 trillion today, an amount exceeding the size of the U.S., European and Japanese economies combined. Bankers quickly, and appropriately, point out that this figure really represents just the "notional" amount, or face value of the derivatives, and not what they could potentially lose. But the amount due, or at risk, is derived (hence derivative) from those vast notional amounts.

Parse the language and it means many banks have a new sideline: gambling. "Derivatives have turned the financial markets into a hi-tech, international, 24-hour casino," notes Richard Thomson, a former merchant banker and author of a book published in London, Apocalypse Roulette: The Lethal World of Derivatives. "Right now you have a small number of banks sharing a very large risk. But this could turn out to be a serious problem if these banks are in the wrong place at the wrong time."

Thomson points out that if one or two large Asian parties default on their derivative contracts, computer screens around the world can be hit within seconds and instantly threaten other contracts. "It's like a bunch of climbers on a mountain all tied by a rope. But if one climber slips and falls into a crevasse, he can quickly drag the other climbers to their end with little chance of time for rescue," says Thomson.

Foreign lenders have already been hit. One large European bank lost not only big money on derivatives but also possibly its independence as well. Union Bank of Switzerland took a $250 million beating from derivatives last year, one reason it rushed into the arms of Swiss Bank Corp.

The American bank that could have the most at stake is J.P. Morgan. Government examiners, who have access to internal bank records denied other mortals, put Morgan's total credit risk from derivatives at $116 billion at the end of last year, the largest of any U.S. bank. Should Morgan suffer a loss of just one-tenth of that from defaulting customers, the bank's equity could be wiped out.

That dam may have started to crack. While the U.S. banking industry pocketed record earnings last year, Morgan's fell 7%, to $1.46 billion. Derivatives are partly to blame. Morgan last year declared it had $659 million in nonperforming assets, 90% of which were defaults from Asian derivative counterparties. Among the defaulters were three South Korean companies, led by SK Securities, which early this year refused to pay $490 million that Morgan claims it is owed.

In this case, SK Securities entered into a currency-swap deal with Morgan in early 1997 whereby SK Securities in effect borrowed U.S. dollars and invested them in Thai baht. But within a year the baht plunged in value, from 25 to 48 to the dollar, and the Korean firms couldn't cough up the dollars to repay Morgan. They subsequently sued Morgan in New York and in South Korea, claiming they weren't properly advised of the risks associated with derivatives.

In other words, they pleaded stupidity. "That's hard to believe," says Mark Brickell, managing director of J.P. Morgan's derivatives group. "When you don't have an alternative, you do the last thing you can do. They didn't have the money at hand, and they chose this route as a way to try to get out of the contracts." Morgan's predicament has nevertheless tarnished its famous bank division's golden debt rating and fueled speculation that the company is a candidate for sale.

Morgan maintains, like all banks, that it has properly managed its risks abroad. "The impact of derivatives over the past 15 years on the banking industry is that today we can manage risks better then ever before," says Brickell. "We may hit a pothole from time to time and even get a flat tire. But we've traveled a long, long way."

The institution holding the biggest bag of derivatives is Chase, with $7.6 trillion. Interestingly, Chase raised the red flag in its 1997 annual report, noting, "Management expects there will be an increase in nonperforming assets in 1998 primarily as a result of the deterioration of credit conditions in a number of Asian countries." Unlike other banks, Chase refused to talk publicly about its derivatives exposure with clients that are below investment grade, but it already has more than $1 billion in total nonperforming assets. A report issued by the OCC examiners puts its total credit risks from derivatives at $81.9 billion, four times stockholders' equity.

And then there's Bankers Trust, which introduced the world to derivatives surprises in 1994. Procter & Gamble sued the bank after absorbing losses of about $150 million on a blown deal, accusing Bankers Trust of misleading it on the risks. The bank agreed to a costly settlement. Now it may face other nasty surprises from Asia. According to SEC filings, the bank has some $5 billion of gross-credit exposure in derivatives to clients that aren't investment grade.

When times get tough, these types of financial instruments are the first to default. "Companies do not view a default on derivatives as face losing," says Tanya Azarchs, a bank analyst with Standard & Poor's. "You can always say you didn't understand the derivative or the bank tricked you or whatever. Customers of derivatives just don't take it as seriously as a loan."

In Asia, governments stung by currency speculators, who often use derivatives, are beginning to turn on their foreign bankers. Citibank reportedly had to cancel plans for a press conference in Taiwan last month to announce a merger with Travelers Group. The problem? Taiwanese authorities denounced Citibank for allegedly circumventing banking regulations involving certain derivatives that allowed the bank to bet heavily against the Taiwan dollar. "The bottom line in this whole derivatives issue is if I'm a trader, I'll take the biggest bets that I can because if I win, I'll go home a millionaire," says Peabody. "If I lose, then the central banks or the IMF [International Monetary Fund] will bail me out. So you've created a moral hazard."

So have the banks been irradiated? One U.S. central banker says no. Financial derivatives during the Asian crisis "worked as expected," said Federal Reserve governor Susan Phillips in a March speech. But that comment may be more a prayer than a conviction. "It's far too early to be handing out Oscars to the banks for how they performed in Asia," says Paul Spraos, publisher of the Swaps Monitor, a derivative newsletter. "It's definitely premature to say the worst of the losses are behind us. These things take time to emerge. "

With Indonesia aflame, a virtual depression in Japan and both Malaysia and Thailand still struggling, the Asian economic crisis is far from over. In the worst- case scenario, one or more large derivatives defaults from Asia and sets off a chain reaction of failures. In the meantime, Howard Greenspan still awaits information to see if his bank will suffer from the fallout. "In the final analysis, this has little to do with Asia," says Greenspan. "It's derivatives themselves. We are into the age of global financial risk."