Chapter 4
Swaps That Shook an Industry
Procter & Gamble versus Bankers Trust
Between 1993 and 1994, Procter and Gamble (P&G) entered into two seemingly innocuous over-the-counter (OTC) derivative agreements with Bankers Trust (BT). On the surface, these interest rate swaps71 appeared to be relatively low-risk transactions. Nevertheless, within five months of signing the first deal, P&G was forced to charge $157 million against its pre-tax earnings ($102 million in after-tax earnings), making this the largest swap-related loss ever recorded by a U.S. industrial company.
The P&G-BT swaps (P&G-BT, for short) are now infamous but not for the reasons you might suspect. Both counterparties were in sound financial health, and their credit ratings were high. BT was well known in the investment banking industry, as an expert in managing financial risk, having earned $144 million from its financial risk management business during the first quarter of 1994 alone. P&G was a globally recognized name in the consumer products industry. In contrast to companies, like Metallgesellschaft and Long-Term Capital Management, which faced near bankruptcy due to their losses of $1.3 billion and $4.5 billion, respectively, or Barings Bank, which was forced to declare bankruptcy because of derivative-related losses totaling $1.3 billion, P&G suffered relatively minor losses, which had little or no negative long-term impact on the company’s share price.72 Clearly, the $157 million hit to P&G’s earnings in 199473 was an unwelcome shock, but for a company with more than $25.5 billion in assets and annual sales in excess of $30 billion, this non-cash charge to earnings was far from life threatening. In fact, for fiscal year 1994, P&G’s net income (even after the swap write-offs) was more than $2.2 billion, and its share price rose as the market shrugged off these derivative losses as one-time aberrations.
If the losses were relatively small, then why did P&G-BT become such a punctuating event for the 1990s? Why is it among the first cases investment bankers cite when discussing issues about whether corporate treasuries (finance departments) should be profit centers or whether corporations should use structured derivatives in their asset and liability management?
One reason the case became so visible was it resulted in a landmark court ruling.74 In an unusual twist for a case settled out of court,75 U.S. District Judge John Feikens, in May 1996, wrote an opinion, providing a rich set of clarifications on the broad class of derivative transactions in which P&G and BT engaged. A second reason P&G-BT gained widespread attention was that it helped spur accounting reforms, increasing corporate disclosure of off-balance-sheet transactions.
A final reason for the case’s visibility and notoriety was that it provided rare and unflattering glimpses of the behind-the-scenes world of investment banking and corporate finance. From 6,500 taped conversations and 300,000 pages of written evidence, BT’s investment bankers portrayed themselves as duplicitous weasels, who would walk over their grandmothers for any sale earning them a small profit.76 P&G’s finance staff came across as having committed the cardinal transgression of taking uncalculated, uncontrolled risks and then suing its investment banker (BT) for losses resulting from P&G’s lack of risk management skills. It was easy for the public to vilify both sides without having to delve into the details of the transactions. Deciding whether these stereotypes and characterizations were fair is left to the reader.
With this brief introduction to set the stage, a deeper look at P&G-BT raises questions of P&G’s motivation for engaging in these deals, the provisions in the swap transactions that led to P&G’s shocking losses, and associated issues addressed by the landmark court ruling. There is much to be learned from mistakes of such magnitude.
P&G’s Motivation for the Swaps
Why did P&G, a company that was supposed to specialize in the production of soaps, deodorants, diapers, cosmetics, food, beverages, and oral care, get involved in derivative-related deals in the first place? Were they in the best interests of P&G shareholders? Was the use of swaps consistent with P&G’s internal policies and procedures? Were shareholders adequately informed of how much risk P&G was taking with its derivative trades? More to the point, could they have obtained an accurate picture of P&G’s financial risks by reading the company’s accounting statements? Were the derivative deals intended to hedge cash flows, lower borrowing costs, or reduce balance sheet gaps, or were they a means of providing P&G with an independent source of profitability from the finance department?
P&G’s two controversial interest rate swaps were not the first derivative deals the company had ever executed. In P&G’s 1994 annual report, the financial statement footnotes showed approximately $2.4 billion worth of derivative contracts on the books. Some of these off-balance-sheet positions were transacted to reduce P&G’s non-operating exposures; but others were motivated by a desire to lower overall borrowing costs and increase net returns, for example, by swapping (i.e., exchanging) fixed-rate interest payments for floating-rate payments (or vice versa) based on P&G’s perceptions of future interest rate movements.
Motives for the U.S. Dollar–Denominated Interest Rate Swap
In early November 1993, P&G transacted the first of its infamous interest rate swaps. The goal of P&G’s treasury in transacting this swap was (supposedly) to reduce borrowing costs to 40 basis points below the commercial paper rate on an expiring five-year interest rate swap that had a $100 million notional principal.77 If it achieved this goal, P&G’s annual savings would have amounted to $400,000,78 which is not much compared to the company’s total annual interest expenses in 1994 of about $500 million. Considering P&G’s eventual losses, these potential savings seem insignificant.
Had economic conditions stayed where they were in November 1993, when the deal was signed, P&G would have ended up borrowing at 75 basis points below the commercial paper rate, which was 35 basis points better than its goal. The problem was an embedded option that expired in six months and had the potential to substantially increase P&G’s interest costs. This embedded option was highly leveraged and had unusual characteristics, including P&G’s high-stakes bet that U.S. interest rates would fall or not rise substantially. From P&G’s perspective, the potential risks of the embedded option were under control because the company intended to unwind the swap position, if needed, prior to maturity, settling for the 40 basis point advantage it desired. Unfortunately, P&G guessed wrong, and as a result, incurred substantial losses.
Motives for the German Mark–Denominated Interest Rate Swap
The second of P&G’s interest rate swaps was a German mark-denominated deal signed in mid-February 1994. It had a notional value of DM 162,800,000 (about $93 million)79 and was structured to “overlay” a pre-existing German mark swap that P&G had done with another counterparty. Therefore, BT’s payments to P&G were tailored to match exactly what P&G had to pay in the other deal. As was the case with its 1993 dollar-based swap, P&G embedded a highly leveraged option in its German mark swap, which made the deal a high-stakes bet that German interest rates would fall or not rise significantly. Again, P&G was wrong, and the consequences were severe.
Motives for Using the Over-the-Counter Market
Why did P&G decide to transact OTC deals with BT rather than use exchange-traded derivatives, for example, on the Chicago Board of Trade (CBOT)? One reason could have been liquidity in the futures markets was too shallow for P&G to transact the volume of business desired without moving prices to its disadvantage. It is more likely the decision was driven by the accounting treatment of exchange-traded derivatives prevailing at that time.
Prior to 1995, U.S. accounting rules gave companies (not just P&G) a strong incentive to prefer structured OTC transactions to exchange-traded transactions. The options P&G embedded into its dollar-denominated and mark-denominated swaps can be viewed as short calls, but U.S. accounting rules do not recognize written options as hedges, which means they do not qualify for hedge accounting. Therefore, P&G would have had to recognize immediately the profit, loss, and cash-flow effects of its exchange-traded options. At initiation, there would have been premium income to report and accounting recognition of the margin posted to the exchange. Then, during the life of the options, P&G would have had to mark its positions to market, thereby paying or collecting variation margin. Finally, P&G would have had to report any gains or losses when it closed out the positions or when the options were exercised at maturity.
For many structured OTC deals, companies were not required to post initial margin, and their positions were not marked to market. Rather than paying an up-front premium, payments were made periodically and netted against other cash flows in the deal. As a result, there was no reportable accounting event when the contract was initiated, and premiums were amortized over the life of the contract. If an embedded option in an OTC deal was amended, unwound, or expired, the financial consequences could be simply incorporated into the net interest payments and receipts, which were then spread over the life of the contract. Similarly, the effect of value changes could be netted and booked as interest income or interest expense. Finally, the notional value of these OTC transactions was reported off balance sheet, as an aggregate figure in the footnotes, which made the value of any individual deal opaque. Therefore, if a position soured, it could be reversed with little or no shareholder concern and analyst notice.80 Regardless of P&G’s motives to use the OTC market for its side bets with BT, the decisions appear to be misguided because P&G ended up selling far too much risk insurance for far too low a price. There is evidence that, if P&G had written calls on CBOT-traded U.S. Treasury bonds for premium income equivalent to what it got from BT, potential losses on its dollar-denominated swap would have been cut by a third or more.81
The U.S. Dollar–Denominated Swap
The first of P&G’s two interest rate swaps with BT occurred on November 2, 1993. The deal was denominated in U.S. dollars, and had a $200 million notional principal and a five-year maturity. Embedded in this interest rate swap was a huge bet that U.S. interest rates would fall or not rise significantly.
P&G’s 1993 swap was a complicated transaction, but as Figure 4.1 shows, the deal can be simplified by separating it into two major parts: (1) a plain vanilla swap, and (2) a speculative gamble on interest rates.
Plain Vanilla Swap
The risks associated with the plain vanilla swap were small and transparent. During the five-year period, BT agreed to pay P&G a fixed annual rate of 5.3 percent on a $200 million notional principal, and, in return, P&G agreed to pay BT a floating annual rate of interest tied to the average daily yield on 30-day commercial paper. Payments were semiannual, commenced in May 1994, and ended in November 1998.
On the plain vanilla side of the P&G-BT deal, there was nothing particularly unusual or risky. One small anomaly was that P&G tied its floating interest payments to the commercial paper rate rather than the normally used London Interbank Offered Rate (LIBOR). Another small variance with standard swap agreements was the commercial paper rate used in the swap was calculated as a daily average rather than the rate on a particular day and at a specific time. Finally, P&G replaced a maturing $100 million swap with one double its size. None of these irregularities added materially to the risks of the deal. Had P&G stopped there and been content with the plain vanilla portion of the deal, the company’s eventual losses, resulting from rising U.S. interest rates, would have been trivial. Unfortunately, there was also a speculative side-bet, and it was this side-bet that created the problems.
P&G’s Gamble: The Speculative Side-Bet
P&G’s speculative side-bet was responsible for virtually all of its losses, and the devil was definitely in the details of this transaction. No premium was paid to P&G in November 1993 when the deal was signed. Rather, premium-like payments began in May 1994 (six months later), when the option matured. Under the terms of the agreement, P&G would receive from BT 75 basis points per year (i.e., 0.75%/year) paid semiannually (i.e., 0.375%/half year) for the next 4.5 years, with payments based on the notional principal of $200 million.
In return for BT’s semiannual payments, P&G would make payments based on a custom-made formula, and the rate would be set in May 1994, six months after the deal was signed. The spread formula used in the deal is shown below (see Equation 4.1). Because it was based on the yield of a five-year U.S. Treasury note and the price of a 30-year U.S. Treasury bond, the P&G-BT deal was called the 5s/30s Swap.82
This side-bet called for cash settlement, so when the fixed interest payments were determined six months after the deal was signed, no ownership rights to U.S. Treasury securities had to be delivered or received. The spread formula just set the cash payments for the remainder of the deal.83
Briefly, here is what the formula meant: In May 1994 (six months after the deal was signed), if the spread formula’s value (i.e., the spread) were zero or negative, P&G would pay nothing for the next 4.5 years, but it would receive $1.5 million each year from BT (i.e., 0.75% of the $200 million notional principal). By contrast, if the value were positive, P&G would be required to pay BT the spread, which would be offset (partially or wholly) by the 0.75 percent payment from BT.
Viewing P&G’s Speculative Side-Bet as a Short Call Option
It is illuminating to view P&G’s side-bet as a short call with a strike price equal to zero, an annual premium equal to 0.75 percent, and the price of the underlying equal to the spread.84 Because the value of an option declines as its maturity falls, P&G had time on its side. If economic conditions did not change, P&G could wait and unwind its position by purchasing a relatively low-priced call and locking in the gain. Of course, problems could (and did) occur if economic conditions changed.
Figure 4.2 shows the profit and loss profile of P&G’s short call. Under the terms of the deal, if the spread on May 4, 1994 (when the option matured) were equal to or less than zero, the option would expire at-the-money or out-of-the-money; P&G would keep the premium, and it would pay nothing for the remainder of the five-year deal. Therefore, all the points to the left of and including zero are fixed at 0.75 percent. To the right of zero, P&G would break even when the spread equaled 0.75 percent (i.e., +0.0075), and for higher values, it would incur losses. For instance, if the spread were +0.10, then P&G would be required to pay BT an annual rate of 10 percent and receive only 0.75 percent from BT, thereby incurring a net cost of 9.25 percent.
If yields moved against P&G, the company’s potential payments were unlimited, and because of the highly leveraged nature of the formula, they increased rapidly. P&G had no way of knowing, when the contract was signed, what it would eventually pay, and because P&G doubled the notional principal of the replacement swap, this deal appears to be largely a speculative bet on the directional shift of the U.S. yield curve.
The biggest threat shown in the spread formula was an upward shift of the U.S. yield curve because the five-year Treasury note yield increased, the price of the thirty-year Treasury bond decreased, and these changes had an amplified (i.e., leveraged) effect on the spread.85 By contrast, a flatter or steeper yield curve had an ambiguous effect on the spread because changes in the Treasury note yield and Treasury bond yield had different relative impacts.86 Consider a steeper yield curve. If the Treasury note yield fell and the Treasury bond yield remained the same, the spread value would fall, and P&G would be helped. If the Treasury bond yield rose (i.e., the Treasury bond price fell) and the Treasury note yield remained the same, the spread value would rise, and P&G would be hurt. Finally, if the steeper yield curve were caused by a combination of changes in the Treasury note yield and Treasury bond yield, the net effect would depend on the magnitude of these changes and the relative sensitivity of the spread value to changes in these yields.
Risk Notepad 4.1
Security Yield versus Price
Figure RN 4.1.1 shows the relationship between the yield and price of a thirty-year zero-coupon bond. Notice how yields and prices are inversely related.
Keep this inverse relationship in mind when considering P&G’s spread formula. An upward shift of the yield curve causes the spread to increase for two reasons. First, a higher yield on the five-year note increases the first term in the formula (i.e., 98.5 × 5-year note yield/5.78%); second, a higher yield on the thirty-year bond causes its price to fall (see Figure RN 4.1.2). Because the price of a 30-year Treasury bond enters the spread formula with a negative sign, any reduction in its value increases the spread.
The Effect of Rising U.S. Interest Rates
Between November 1993 and May 1994, the U.S. Federal Reserve preemptively tightened monetary conditions to reduce the risk of inflation. U.S. interest rates rose and the difference between the short-term and long-term interest rates fell, indicating a flattening of the yield curve (see Figure 4.3). During these six months, the yield on thirty-year U.S. Treasury bonds rose by 1.29 percent, from 6.06 to 7.35 percent, causing the long-term bond price to fall from 102.58 to 86.84. At the same time, the yield on five-year Treasury notes rose by 1.69 percent, from 5.02 percent on November 2, 1993 to 6.71 percent on May 4, 1994. As a result, P&G’s floating interest rate soared, and its embedded option began to spill red ink.
BT contacted P&G on 22 February 1994 with news that the 5s/30s swap spread had increased to the point where P&G would have to pay 4.6 percent above the commercial paper rate. This meant that P&G’s goal of borrowing at 40 basis points below the commercial paper rate was up in flames. P&G decided to stay with its position rather than lock in an early rate. In part, the decision was based on forward yields for five-year and thirty-year Treasury securities, which indicated moderating interest rates in the future. The decision was also based on what P&G felt was a small likelihood that the Federal Open Market Committee (FOMC) would substantially increase U.S. interest rates or disadvantageously tilt the yield curve during the next few months. Normally, the FOMC meets about once every six weeks, and, when changes are needed, it adjusts the federal funds rate by increments of 0.25 percent. Based on past Fed actions, P&G bet that yields would not rise enough to wipe out its 75 basis point advantage.
Table 4.1 compares the payments P&G would have made in November 1993, when the deal was signed, to the payments in May 1994, just six months later, when the terms of the deal were supposed to be set. On November 2, 1993, the yield on five-year Treasury notes was 5.02 percent, and the price of a thirty-year Treasury bond was 102.58. Therefore, the spread equaled -17.03 percent, which was out-of-the-money. In stark contrast, if P&G had waited until May 4, 1994 (it didn’t), the company would have paid an annual rate of 27.50 percent and received only 0.75 percent in return, for a net payment of 26.75 percent, which is $53.5 million per year!
Table 4.1: Five-Year Treasury Note Yield, Thirty-Year Treasury Bond Price, and Spread
Figure 4.4 generalizes the results and shows that, as long as the yields on the thirty-year Treasury bond and five-year Treasury note remained below (about) 6 percent and 6.5 percent, respectively, P&G’s spread would have equaled zero. In other words, there was a lot of flat terrain (i.e., yield-price combinations) over which P&G could have earned 75 basis points each year and paid no net interest. Under these circumstances, combining the two parts of the P&G-BT transaction (i.e., the plain vanilla swap and the gamble), P&G would have ended up paying 75 basis points below the floating commercial paper rate on a $200 million notional principal, which at that time would have been a borrowing rate better than the U.S. government paid. By contrast, if interest rates rose, the premium paid by P&G increased rapidly. Figure 4.4 shows how steeply P&G’s costs increased with every marginal rise in yields.
Fortunately, P&G did not experience such severe losses because it was able to mitigate them in two ways. First, on January 20, 1994, the company renegotiated the terms of the swap so that BT paid a premium of 88 basis points per year instead of the 75 basis points in the original agreement.87 Second, P&G hedged its open position on March 29, 1994, about a month before the spread-setting date of May 4, 1994. As a result, it locked in a spread equal to 15 percent.88 Subtracting the (new) annual premium of 0.88 percent, this amounted to yearly net payments of 14.12 percent (see Figure 4.5).
So, how much did P&G finally lose on its side-bet? Table 4.2 calculates the discounted present value of P&G’s losses, based on the March 29, 1994 spread value of 15 percent. P&G’s semiannual payments to BT began in November 1994 and continued until November 1998. BT’s semiannual payments to P&G began in May 1994 and continued until November 1998. P&G was required to pay BT an annual rate of 15 percent (i.e., 7.5% semiannually) on a notional principal of $200 million, and BT was required to pay P&G an annual premium of 0.88 percent (i.e., 0.44% semiannually). Discounted at a 7 percent annual swap rate (i.e., 3.5% semiannually), the present value of P&G’s net payments to BT amounted to an astonishing $105.8 million! This payment was astonishing for a deal that was undertaken, in the first place, to save P&G 40 basis points in annual interest costs ($400,000 per year) on a maturing $100 million swap.
Table 4.2: Loss on P&G’s $200 Million Side-Bet
Losses on P&G’s U.S. Dollar Interest Rate Swap
What happened to the plain vanilla interest rate swap in which P&G received an annual rate of 5.3 percent and paid the floating commercial paper rate? To calculate P&G’s loss on the swap, compare the swap’s value before and after interest rates changed. At initiation, an interest rate swap normally has a zero value. The cash flows in a fixed-for-floating rate swap are identical to the cash flows from simultaneously selling a floating-rate security and purchasing a similarly sized fixed-rate security. In P&G’s case, its swap cash flows were equivalent to selling a $200 million, five-year note yielding the commercial paper rate and using the funds to purchase a $200 million, five-year note yielding 5.3 percent. At inception, this deal would be an exchange of equals with no net value.
Table 4.3 shows what happened to P&G when swap rate rose to 7 percent. The discounted present value of P&G’s stream of fixed cash inflows fell from $200 million to approximately $191 million, which was a drop of $9 million.89 If we compare P&G’s swap-related losses with the losses on the side-bet, the interest rate swap was much safer. For the same increase in interest rates, the side-bet lost about twelve times more than the interest rate swap.
Table 4.3: Loss on P&G’s Plain Vanilla Interest Rate Swap
Almost immediately after P&G transacted its $200 million interest rate swap in November 1993, U.S. interest rates began to move against its position (see Figure 4.3). Nevertheless, P&G remained convinced that interest rates would fall; so, in February 1994, the company placed another costly wager, making the same bet on German interest rates as it did on U.S. interest rates.
German Mark-Denominated Interest Rate Swap
On February 14, 1994, P&G increased the ante by transacting a 4.75-year interest rate swap, which turned out to be a huge bet that German interest rates would fall or not rise significantly. The terms of the P&G-BT German mark (DM) swap in 1994 were as quirky as the 1993 U.S. dollar swap. The deal ran from January 16, 1994 (backdated) to October 16, 1998 and had a notional principal of DM 162,800,000 (i.e., about $93 million). From January 1994 to January 1995, BT agreed to pay P&G the German mark two-year constant maturity swap rate90 (i.e., DM two-year swap rate) plus a 233 basis point premium. These payments exactly matched what P&G owed on the overlaid swap. For the same period, P&G agreed to pay BT the DM two-year swap rate plus a 133 basis point premium. If you are scratching your head, wondering whether you misread the last sentence, rest assured that your understanding and math are correct. For the year running from January 16, 1994 to January 16, 1995, BT promised to pay P&G a net premium of 1 percent on the notional swap principal. It was a good deal for P&G.
During the second year, the terms changed, and this is where P&G made its interest rate bet. From January 1995 to October 1995, BT continued to pay P&G the DM two-year swap rate plus 233 basis points, but now P&G added a spread to its usual payment. The payments changed once again, but only slightly, from October 1995 to maturity in 1998. Instead of basing their periodic payments on the DM two-year swap rate, BT paid the DM three-month LIBOR plus 233 basis points, and P&G paid the DM three-month LIBOR plus the spread. This change was made to ensure that the new swap mirrored exactly the payments that P&G had to make on its old swap.
Here is how the spread formula worked. An interest rate band was established with its lower and upper limits pegged at 4.05 percent and 6.01 percent, respectively, for the four-year DM swap rate. This interest rate band became known as the “wedding band.” On February 25, 1994, the upper limit of the wedding band was raised from 6.01 to 6.10 percent; so, let’s use the revised rate for our discussion (see Figure 4.6).91 If the DM four-year swap rate remained within the band for the entire year, P&G’s spread would equal zero. As a result, it would have no additional interest costs for the remainder of the agreement, which means it would have received a net 1 percent payment each year from BT, which was a savings of DM 1,628,000 per year.92
However, if the band was breached, P&G’s spread would equal ten times the difference between the DM four-year swap rate (on the rate-setting date) and 4.5 percent93 (i.e., spread formula = [10 × (4-year DM swap rate—4.5 percent)]). Tying its spread payments to a leverage factor of ten greatly increased the risks for P&G. P&G’s spread could have been positive (costing it more) or negative (costing it less). For example, if interest rates went outside the limits during the year, P&G would pay more if the DM four-year swap rate on the rate-setting date was above 4.5 percent and less if it was below 4.5 percent (see Table 4.4).
Table 4.4: Summary: Spread Owed by P&G to BT after First Year of the Swap
| Spread = 0 percent |
| –If the German mark swap rate remained within the range of 4.05 to 6.10 percent during the year |
| –If the limits were breached during the year and the DM four-year swap rate was 4.5 percent on the rate-setting date. |
| Spread = 10 x (Four-Year DM Swap Rate on January 16, 1995 – 4.50 percent) |
| –If the German mark swap rate moved outside the 4.05–to-6.10 percent band during the year. |
Because the notional principal was denominated solely in German marks, P&G’s 1994 swap was an interest rate swap and not a cross-currency swap. If the transaction were a cross-currency swap, then equivalent notional principals in German marks and U.S. dollars would have been established up front, and there would have been an exchange of principals at the termination of the contract. By contrast, P&G was taking mainly an interest rate bet with only a small wager on the dollar value of the net German mark interest payments it would receive or pay. Therefore, the risks were much smaller than they would have been with a cross-currency swap.
In the beginning of February 1994, the DM swap rate was about 5.35 percent, but on February 4 (just ten days before P&G transacted its swap), the U.S. Federal Reserve tightened significantly U.S. monetary policy. As a result, U.S. interest rates soared, causing international interest rates, including the German mark swap rate, to rise.
On March 1, 1994, BT informed P&G that its DM swap was approaching the upper limit of the band. If P&G wished to unwind the deal, it would cost a whopping 11.9 percent. P&G was confident of its interest rate forecast and decided not to unwind the deal or to renegotiate any of its conditions, such as the upper limit or settlement date. By the next morning (only fifteen days after the swap was signed), the DM four-year swap rate already exceeded the wedding band’s upper limit. P&G was in trouble and knew it, but the company waited until April 11 to unwind the position. By that time, the spread had increased to 16.40 percent, and the swap had lost more than $60 million!
The Suit against Banker’s Trust
P&G was fighting mad and brought charges against Bankers Trust Co. and BT Securities Corporation94 on grounds of racketeering, fraud, misrepresentation, breach of fiduciary duty, negligent misrepresentation, and negligence.95 The original suit, which included only the 1993 U.S. dollar interest rate swap, was filed on October 27, 1994. On February 6, 1995, P&G amended its lawsuit to include the German mark swap, which was transacted on February 14, 1994. On September 1, 1995, the court permitted P&G, once again, to amend its complaint. BT rose to the challenge by demanding that P&G pay the amount it owed on the two swaps, which (BT claimed) was more than $200 million.
Managing a large portfolio of off-balance-sheet positions and, at the same time taking on a considerable number of newly structured deals can be challenging; so, it is easy to understand how P&G might have relied heavily on the price estimates, market information, advice, and position tracking of its investment bankers, in general, and BT, in particular. P&G was convinced that it could lock in advantageous rates on its swaps long before maturity, simply by contacting BT and unwinding the deals. In fact, the company looked to BT for support with the timing, pricing, and execution of such deals, but if this were so, why did P&G wait so long to unwind its positions and, in the end, lose so much?
P&G claimed that it was a victim of not understanding how seriously its position had deteriorated. The cost to unwind P&G’s structured deals with BT came from a proprietary, multivariate-pricing model developed by BT. P&G argued that it never agreed to the formula in the first place and, because it was a proprietary black box, could not check the objectiveness or accuracy of BT’s assumptions and conclusions. Had it known the high cost to unwind the 5s/30s swap, P&G claimed it never would have entered the German mark deal. To P&G, BT’s refusal to reveal its pricing model and assumptions amounted to non-disclosure of material information and, therefore, was grounds for P&G’s charges of fraud.96
BT agreed that its pricing model was proprietary but asserted that it was P&G’s responsibility to actively manage its own derivative positions. In fact, BT advised P&G on the day the 5s/30s swap was signed to mark the deal to market and proactively manage it, so as not to “get burned.”97 Furthermore, BT offered, on numerous occasions, to quote P&G a price for any amendments it wanted make to the option-like component of the 5s/30s swap. The bank also offered to provide P&G with hard copies of any swap valuation analyses and subsequently sent P&G a diskette with BT’s pricing algorithm and embedded assumptions so that P&G could calculate any spread scenarios it wanted. In early March 1994, BT claimed that it offered to send a representative to P&G’s Cincinnati headquarters with the computer model, but P&G canceled the visit stating that it was not needed.
From P&G’s perspective, BT was the professional and had a fiduciary responsibility to its relatively unsophisticated users. BT rebuffed this assertion by citing numerous other swaps in which P&G was a party—some of which had even higher degrees of leverage than the P&G-BT deals and earned above-market rates. BT indicated that P&G received advice regularly from other financial advisors and investment bankers, such as Merrill Lynch, Goldman Sachs, and J.P. Morgan, who were BT’s competitors and with whom P&G did many deals. To BT, P&G was a sophisticated player in the world of high finance and was capable of marking its positions to market, using the formulas agreed to in the swap agreements.
It is clear that pricing derivative contracts can be difficult, may require advanced mathematical expertise, and involve sophisticated proprietary models, but tracking their gains and losses (i.e., marking positions to market) once they are up and running is not complicated. All that is needed is an ability to do basic discounted present value analysis—a skill possessed by anyone with an introductory course in finance and access to a calculator or a computer spreadsheet (e.g., EXCEL). Even if P&G were unable to determine the exact price to unwind its positions, just the daily act of marking positions to market should have served as fair warning to P&G that its swaps had sailed into treacherous waters.
Risk Notepad 4.2
Value at Risk
One technique that might have helped P&G quantify the risks of its swaps with BT is value at risk (VaR) analysis. VaR is a statistical technique that estimates the minimum amount a company can expect to lose on a portfolio over a given time and with a defined level of certainty. Using this technique, treasurers can make statements like: Based on historic returns and volatilities, we at P&G are 95 percent sure that our portfolio will lose no more than $10 million over the next week, which means that there is a 5 percent chance we could lose $10 million or more. A study based on P&G-BT was conducted a few years after the case was settled.98 It found that a VaR analysis would have provided P&G with timely warning signals about the risks of its U.S. dollar-denominated swap.
Using a six-month time horizon (i.e., the interest payment period) and a 95 percent confidence interval, the study determined that the VaR on P&G’s swap was approximately seven to ten times greater than the initial $6.65 million value of the swap contract. As it turned out, P&G lost much more than the VaR analysis estimated, which only goes to show that companies should beware of the unknown risks lurking in the upper 5 percent tail of the VaR distribution. Nevertheless, had P&G known the VaR exposure on its U.S. dollar swap, perhaps that knowledge would have deterred the company from entering into the transaction, or P&G would have closed out its position far earlier.
The P&G-BT Settlement
The P&G-BT lawsuit was eventually settled out of court, with both sides claiming victory. BT claimed victory because P&G agreed to pay BT $35 million of the nearly $200 million it owed, and P&G assigned to BT the benefits of another disputed derivative investment that was valued between $5 million and $14 million. P&G claimed victory because it recovered approximately 83 percent of its total losses,99 but it is clear that the victory was costly to both sides because of the collateral damage to their reputations.
How Did BT Fare After the Swaps?
Most of this chapter has focused on the risk-management practices and losses of P&G. Little or nothing has been said about BT, but there are some important points to consider. Typically, when a swap dealer takes a position (as BT did with P&G), it tries to hedge the transaction as soon as possible. In this way, the dealer earns a spread whether interest yields rise or fall, and the risk is neutralized. As BT mentioned in its legal response to P&G’s accusations, it did not need P&G to lose money for BT to profit, or vice versa.100
If BT had hedged the P&G deal, there would have been a major problem when P&G refused to pay its losses. Most of these payments would have been earmarked for the counterparties BT lined up to hedge the P&G deal. For example, if P&G owed BT $157 million on the two swaps, BT would owe most of those funds to its counterparties and would have to pay them regardless of whether P&G paid its side of the swap (see Figure 4.7). The contingent nature of this contract only released BT from paying P&G if P&G defaulted on its side of the deal. P&G’s default would have had no impact on the independent hedging transactions that BT did with other counterparties.
There was speculation that BT had a stake in doing this deal with P&G because BT needed to hedge an inventory of existing positions. According to this view, BT purposely deceived P&G into believing the swaps were benign.101 P&G openly speculated that BT entered into more than $3 billion in counterparty transactions after the P&G deal was completed to fully hedge its exposure, which may explain why P&G was shocked at the cost of locking in a fixed rate after conditions turned sour.102 We will probably never know if BT had an existing exposure or if BT hedged the P&G swaps after signing the documents. The case was settled out of court, so it never went through the discovery phase, which is when all the internal files, memos, and e-mails would have been entered into the public record. Regardless, if BT was hedged, the out-of-court settlement with P&G must have significantly affected its earnings.
P&G-BT from an Investor’s Perspective
It is unlikely that an investor, sensitive to risk and considering whether to invest in P&G, would have gleaned any information about the risk-return profile of the company’s off-balance-sheet (derivative) transactions from studying P&G’s 1993 annual report. For instance, in 1993, P&G reported a $17 million gain on the derivative positions it took to hedge foreign exchange risks, but it made no mention of a $122 million loss on interest-related derivatives.103 P&G was not the exception. Many companies revealed, in the footnotes of their financial reports, only the notional values of their derivative positions; some mentioned their maturities, but few revealed important details, such as swap payments, swap receipts, and credit risks. On the asset side, companies purchasing structured notes for investment provided little or no information about their liquidity or riskiness. Structured securities were just lumped together with other interest-earning assets and put into categories with names like cash and marketable securities.
Perhaps one of the positive results of the P&G-BT swap was that it provided clear evidence of how poorly corporations reported their off-balance sheet positions (i.e., forwards, futures, options, and swaps). This lack of transparency was a primary stimulus behind the recommendations and subsequent accounting reforms (e.g., FASB-133)104 made by the U.S. Financial Accounting Standards Board in 1995.
The Landmark P&G-BT Court Opinion
Some of the important legacies of the P&G-BT swaps were the published court opinions resulting from this case because they were among the first clarifications of legal controversies dealing with swaps.105 This section reviews the most important court opinions connected to swap transactions.
Major Legal Issues
One of the key issues addressed by the court was whether swaps are securities. If they are, swaps can and should be subject to regulatory supervision by agencies such as the Securities and Exchange Commission (SEC) or Commodity Futures Trading Commission (CFTC). By contrast, if they are over-the-counter transactions, swaps are outside the jurisdiction of these regulators.106
Another issue addressed by the court was whether investment bankers have a fiduciary responsibility to their customers. Fiduciaries are expected to act on behalf of their customers in a transparent, loyal manner and in ways that intentionally avoid self-dealing. A higher standard is expected from fiduciaries than merely acting in good faith because their transactions with customers are not arm’s length. Examples of relationships where agents have fiduciary responsibilities are attorneys to clients, trustees to beneficiaries, executors to inheritors of estates, guardians to children, and directors to shareholders. For a company as large and seemingly well run as P&G to claim that it did not fully understand its multi-hundred million-dollar transactions and, therefore, deserved fiduciary treatment raises some uncomfortable questions.
If swap dealers do not have a fiduciary responsibility, then what legal and ethical disclosure obligations, if any, do they owe their customers? For instance, if an investment banker fails to disclose important information about a swap transaction, can this transgression be prosecuted by customers on the common-law grounds of fraud?
An Unusual Court Opinion
On 8 May 1996, Judge John Feikens of the Southern District Court of Ohio in Cincinnati rendered an opinion on P&G’s amended charges against BT.107 The court opinion was unusual for two reasons. First, it was issued after P&G and BT had settled out of court, which is rare. Second, the opinion was unusual for what it did not say. In cases decided by summary judgment, the facts of the case are not in dispute, so these “facts” should be the focus of the decision. Judge Feikens’ opinion was very forthright in its conclusions, but it was not specific about the facts in the case that led him to his conclusions.
Summary of the Court Opinion
Judge Feikens had already ruled that P&G’s charges against BT under the Organized Crime Control Act of 1970 (i.e., the Racketeer Influence and Corrupt Organizations [RICO] Act) were groundless because P&G failed to prove that BT was part of a corrupt organization distinct from the parent holding company.108 His opinion on May 8 focused on securities law and fiduciary duties of investment bankers. As far-fetched as the racketeering charge might seem, its early resolution was important to BT because, if P&G had been successful in proving these charges, P&G could have then sued BT for treble damages (as much as $600 million), and a jury might have been willing to award P&G that much money.
In his written opinion, Judge Feikens concluded that P&G-BT’s “5s/30s and DM swap agreements [were] not securities as defined by the Securities Acts of 1933 and 1934 and the Ohio Blue Sky Laws; that these swap agreements [were] exempt from the Commodity Exchange Act; that there [was] no private right of action available to P&G under the antifraud provisions of that Act; and that the...choice of law provision in the parties’ agreement preclude[d] claims under the Ohio Deceptive Trade Practices Act”109 (emphasis added). Regarding P&G’s charges regarding BT’s negligent misrepresentation, breach of fiduciary duty, and negligence, Judge Feikens concluded, “that as a counterparty to swap...agreements, BT owed no fiduciary duty to P&G. P&G’s claims of negligent misrepresentation and negligence [were] redundant”110 (emphasis added). In short, the court found that P&G should not be relieved or protected from the harsh ramifications of its own poorly negotiated deals. At the same time, Judge Feikens ruled that dealers with superior knowledge and information (e.g., data) relative to their customers had a legal responsibility to disclose material information.
Disclosure Reform after P&G-BT
The financial accounting standards practiced in the United States today are the result of concerted efforts by the Financial Accounting Standards Board (FASB) to improve the clarity of corporate financial reporting. Even prior to the P&G-BT swap debacle, FASB had been trying to determine the proper accounting treatment for derivatives. It was apparent to most observers that U.S. accounting standards for off-balance-sheet transactions were inadequate. P&G-BT helped accelerate the pace of reform because it focused the public eye on the downside risks of misunderstood and unattended derivative transactions. P&G-BT, along with many other blatant examples of derivative abuse in the 1990s, highlighted the incomplete and potentially misleading job U.S. companies were doing reporting their financial conditions.
Relatively soon after P&G-BT was settled, FASB and the SEC passed and implemented a bevy of reforms (e.g., FAS 119, FAS 133, and FAS 138) with respect to the measurement, recognition, and disclosure of accounting information on derivative financial transactions. FASB and the SEC were, by no means, at the end of their accounting reforms, but they had come a long way toward making financial transactions more transparent to investors and regulators.
Should Corporate Treasuries Be Profit Centers?
Ever since the legal battle between P&G and BT in 1994 and 1995, many investment bankers and investment analysts have been critical of corporations perceived to be speculating in derivative instruments to enhance corporate profits. Nevertheless, these same investment bankers agree that prudently managed derivative transactions are an effective way to control market, credit, and liquidity risks. On one side, P&G felt betrayed by BT, but on the other side, BT maintained that P&G fell victim to its own decision to run the company’s treasury (finance) department as an independent profit center or hedge fund.
Should the finance departments of manufacturing companies be profit centers? Was P&G foolish to have expected profits from a group that should have been more concerned about borrowing, hedging, and managing cash flows? When finance departments become profit centers, do they increase or decrease the volatility of a company’s cash flows and net income?
Companies like P&G that transform their treasuries into profit centers and use their financial resources as tactical weapons must accept the consequences of new risks, which are much different from those typically connected to their core operating activities (i.e., manufacturing, marketing, and distribution). To many observers, any nonfinancial company taking this tactical step is acting in direct opposition to the general canons of conservative finance.
Conclusion
P&G-BT was a punctuating event in the 1990s, a period of rapid development in the derivatives industry. Rarely do you hear the chief financial officer of a multi-billion-dollar company admit that he and his staff lacked a clear understanding of transactions valued at nearly $300 million. When the messy details of the P&G-BT swap were investigated, two conclusions emerged. First, P&G made large bets on the directional movement of U.S. and German interest rates. If it had been correct, the company would have borrowed at rates better than governments can achieve. But P&G’s forecasts were incorrect, the company cut its losses too late, and, in the end, it was clear that the compensation P&G negotiated with BT was inadequate for the risks assumed. Second, once the swaps were priced and accepted by both parties, P&G seemed incapable of tracking their market risks (or unwilling to do so). As a result, losses on the combined notional principals of a bit less than $300 million mounted until P&G closed out its positions with pre-tax losses of $157 million. This was a whopping loss for a deal of that size.
P&G-BT was also significant because it helped fuel the drive for accounting disclosure reform regarding off-balance-sheet transactions and because it resulted in a significant District Court opinion on vital issues related to swap transactions. Judge John Feikens ruled that:
–Swaps are not securities; and
–Swaps dealers do not owe a fiduciary responsibility to their customers; at the same time, they do have a legal responsibility to disclose material information, especially when swap dealers have superior knowledge and information.
Since P&G-BT, many Wall Street practitioners and academic analysts have opposed corporate treasuries being profit centers. Nevertheless, this issue will keep weaving in and out of discussions for years to come because so many companies continue to put their treasuries (intentionally or unintentionally) in this position.
Review Questions
- In its 1993 and 1994 interest rate swaps, was P&G speculating or hedging? Explain.
- In its 1993 dollar-denominated interest rate swap, how much did P&G expect to gain? How much did it eventually lose? Is there any way to justify this tradeoff on financial grounds?
- Explain the gamble P&G took on its 1993 dollar-denominated interest rate swap.
- Explain the “wedding band” in P&G’s 1994 German mark interest rate swap.
- Summarize what went wrong and caused P&G to lose such large amounts on its interest rate swaps.
- Present arguments why BT should have been required to give P&G its pricing model. Then present arguments to the contrary.
- In the lawsuit between P&G and BT, explain which company, you believe, won.
- If BT had hedged its U.S. dollar interest rate swap with P&G, explain how BT would have lost twice when the deal collapsed.
- Why was accounting transparency an important issue in the P&G-BT swap controversy?
- What is a fiduciary? Do swap dealers have fiduciary responsibilities to their customers? Why is this important?
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Appendix 4.1
What Is an Interest Rate Swap?
A plain vanilla interest rate swap is an off-balance-sheet agreement between two counterparties to exchange periodic cash flows. Often, they are used by companies to transform cash flow payments (or receipts) from fixed to variable rates of interest (or vice versa). These transactions have medium-term to long-term maturities, and the principal is notional, which means it is not exchanged.
An example clarifies the interest rate swap. Suppose P&G borrowed $100 million by issuing notes with a six-year maturity and fixed interest rate of 5.3 percent. After one year, interest rates remained the same, but P&G’s Finance Department expected interest rates to fall in the future. Therefore, it began looking for ways to switch its fixed-rate debt into variable-rate debt that was tied to the (floating) commercial paper rate. One way to accomplish this goal would be for P&G to issue new, floating-rate notes worth $100 million and use the proceeds to pay off its old, fixed-rate debt. This alternative would be possible if the original notes were callable but problematic if they were not. Moreover, P&G would have to bear the additional costs of calling in its old notes and issuing new ones. An easier, and usually less expensive, way to accomplish the same goal would be to use an interest rate swap.
With an interest rate swap, P&G would contact a swap dealer, like BT, and agree to exchange fixed-rate cash flows for floating-rate cash flows, for five years, based on a notional value of $100 million—which exactly matches the size and remaining maturity of the original note issue. Suppose the terms of the P&G-BT swap were as follows: For each of the next five years, BT agreed to pay P&G a fixed, 5.3 percent rate on the notional principal of $100 million, and P&G agreed to pay BT the commercial paper rate on the same notional principal. Figure A 4.1.1 shows graphically the periodic cash flows among P&G, BT, and investors in P&G’s original (5.3%) notes.
As Table A 4.1.1 shows, instead of paying a fixed rate of 5.3 percent per year, the interest rate swap transformed P&G’s interest payments into floating commercial paper rate payments.
Table A 4.1.1: Borrowing Costs, Swap Payments, Swap Receipts, and Net Payments
| P&G | BT | |
| P&G’s Original Note Issue | ||
| Interest Expense | 5.3% | NA |
| Interest Rate Swap | ||
| Swap Receipts | 5.3% | Comm. Paper % |
| Swap Payments | Comm. Paper % | 5.3% |
| Net Interest Expense | Comm. Paper % | 5.3% ─ Comm. Paper % |
There are two points to keep in mind with an interest rate swap: First, it is an independent agreement that has nothing to do with the original loan. Therefore, any failure by BT to abide by the conditions and terms of the swap agreement has no bearing on P&G’s obligations to pay back its original note-holders. Second, because the swap does not involve an exchange of principal it is not a source of funds for P&G or BT. Rather, the principal is notional, meaning it is used only to determine the periodic cash flows that must be paid. Because principal is never at risk, interest rate swaps are substantially safer than outright loans. If BT defaulted on its side of the deal, P&G would have only the net interest receipts or payments at risk. This interest exposure is reduced even further because swaps are contingent contracts, which means if one counterparty stops payment on its side of the deal, the other counterparty is also released from its swap payment obligations.
P&G’s motivation for entering into this swap was clear: The company wanted to profit from its expectation that U.S. interest rates would fall, but why would a swap dealer, like BT, enter into it? Swap dealers prefer to lock in small profitable spreads rather than take unhedged positions. Therefore, BT would try to hedge the P&G deal as soon as possible. Figure A 4.1.2 shows the results if BT finds a counterparty, for example The Walt Disney Company (DIS), to offset the P&G swap. Under the terms of the five–seven year agreement, BT pays Disney the commercial paper rate and Disney pays BT 5.4 percent. If P&G and Disney do not default before maturity and carry out their sides of these deals, BT would be guaranteed a net return of 0.10 percent for each of the next five years.
