Infectious Greed (41 page)

Europeans had learned about the dangers of derivatives in 1993 when
Metallgesellschaft, a German conglomerate, lost $1.4 billion on oil derivatives. The losses at Metallgesellschaft illustrated the difficulty of distinguishing between
hedging
(reducing risk) and
speculating
(increasing risk with the hope of higher returns), and also foreshadowed future problems in the energy markets, including the electricity crisis in California and the related collapse of Enron. Unfortunately, few people saw the parallels.

Like any oil refiner, Metallgesellschaft was exposed to the risks of changes in the price of oil and oil-related products. If oil prices went down, the firm would buy cheaper oil, but probably would earn less from selling refined products. If oil prices went up, the opposite would be true. Thus, the major risk facing the firm was the difference between the price of unrefined oil at the time of purchase and the price of refined oil products at the time of sale.

During the early 1990s, a U.S. subsidiary of Metallgesellschaft agreed to sell millions of barrels of oil products at fixed prices for up to ten years. Was the firm hedging or speculating? On one hand, the long-term contracts looked like hedges because they locked in a price. On the other hand, the contracts created a new risk: now if prices rose, the firm would pay more for unrefined oil, but would not capture any price increase from its sale of unrefined products.

Metallgesellschaft hedged part of this exposure to rising oil prices by buying short-term oil futures on the New York Mercantile Exchange (NYMEX), the exchange that would figure prominently in Enron's collapse. It also bought over-the-counter oil derivatives in unregulated markets. What about these trades? Were they hedging or speculating?

In late 1993, oil prices dropped and Metallgesellschaft began losing money on its futures positions. Theoretically, the firm could make up for these losses by selling oil-related products in the future at the prices it had locked in on its long-term contracts, which were now higher than prices available in the market. But as the losses on the short-term oil hedges increased, the firm had to pay hundreds of millions of dollars right away, years before the future gains from its long-term contracts. On December 17, 1993, directors of the firm's German parent took control of the hedging operation and began selling off the short-term contracts, at huge losses.
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By January 1994, the firm had lost more than a billion dollars.

Experts disagreed about who was to blame for the German refiner's collapse, and whether the hedging strategy was, in reality, just speculation. Christopher Culp and Merton Miller (the Chicago economist who
had argued that derivatives were used to avoid regulation) maintained that the trades were hedges and made economic sense; they blamed the German directors for abandoning the hedging strategy. John Parsons and Antonio Mello concluded that the hedging strategy was an over-hedge that was so big it was speculative.
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U.S. regulators cracked down on Metallgesellschaft more than they did against U.S. firms in similar situations. (This was typical: unless a case created political tensions, financial regulators in one country generally preferred to bring harsher charges against a foreign company than against one of their own.) The Commodity Futures Trading Commission charged Metallgesellschaft's U.S. subsidiaries with trading illegal futures contracts and with having inadequate controls, and imposed a $2.5 million fine. Regulated futures contracts—like regulated securities—had to be registered with the CFTC or exempt from registration, and firms that dealt in futures were required to have adequate controls in place, as a prudential measure to protect parties dealing with firms in futures. Several members of Congress criticized the charges, as did former CFTC chair Wendy Gramm, who by that time was working as a director of Enron.
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Like Metallgesellschaft, the state of California (and its electric utilities) also faced a potential mismatch between the long-term cost of electricity production and short-term revenues from electricity consumers. Because short-term rates were capped by law, California was vulnerable to an increase in electricity prices unless it entered into a long-term contract to purchase electricity. At first, the state of California did not hedge, and it lost billions of dollars when electricity prices increased—in part, it was alleged, because energy companies were manipulating prices in markets similar to those Metallgesellschaft had used. Later, California locked in long-term electricity prices by entering into swap contracts with various energy companies. The Metallgesellschaft and California examples showed that it was very difficult for an institution to control its hedging operations, and that it was very easy to lose a billion dollars or more in the energy-derivatives markets.

The German central bank warned investors in October 1993 that derivatives trading “could cause a chain reaction and endanger the entire financial system.”
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Dutch, German, and Belgian authorities prosecuted a few criminal cases against various derivatives firms in 1994, in an attempt to reduce the chance of more serious problems in the future.
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In January 1995, Netherlands Central Bank Governor Wim
Duisenberg remarked, “What's needed is that companies that use derivatives tightly control their use and the risks taken. You shouldn't give sophisticated weapons to children.” Investors and regulators outside the United States apparently were cognizant of the risks associated with financial innovation. But they were unprepared for the financial crises beginning in December 1994.

 

 

D
uring the summer and fall of 1994, investors from the United States, Europe, and, especially, Japan, poured money into investments in Mexico, even though the Mexican central bank was under pressure and political tensions were rising. The Mexican central bank was the key to understanding how Mexico's currency system worked. The value of the Mexican peso was established primarily by supply and demand, but the central bank periodically intervened, buying pesos when it thought the value was too low and selling when it thought the value was too high.

Specifically, the Mexican central bank established a
currency band—
a range of peso values it promised to maintain. The band expanded over time; but, for illustrative purposes, assume it was between 3.0 and 3.5 pesos per dollar. That meant that if the peso moved to 3.0, the central bank would enter the market, selling pesos—which it could print anytime it wanted—and buying U.S. dollars. The value of the peso would never move to 2.9, so long as the central bank was willing to transact at 3.0. Likewise, if the pesos moved to 3.5, the central bank would enter the market, selling U.S. dollars—from an accumulated reserve—and buying pesos. The value of the peso would never move to 3.6, so long as the central bank was willing to transact at 3.5.

For several years, the peso had been at the “top” end of this range—3.0 pesos per dollar, where the peso was more valuable. (To see that the peso was more valuable at a rate of 3.0 than a rate of 3.5, consider what someone in Mexico could get for 30 pesos in each case: $10 at a rate of 3.0, but less than $9 at a rate of 3.5.) Mexico's “strong” currency policy had made the country attractive to foreign investors, who could earn high returns on Mexican government bonds and stocks, and not be hurt by a weakening currency.

Over time, the peso began moving to the “bottom” end of the range—closer to 3.5 pesos per dollar—and the central bank became obligated to buy pesos in exchange for U.S. dollars at the rate of 3.5. The downward movement of the peso was due to a variety of factors, the most important
of which was that inflation rates and interest rates were higher in Mexico than in the United States. This differential encouraged investors to borrow in U.S. dollars and invest in pesos. If the central bank hadn't established a currency band, investors might have worried that their gains from such a strategy would be wiped out by a decline in the value of the peso relative to the U.S. dollar. But because the central bank had committed to prop up the value of the peso—buying at the rate of 3.5—investors were assured of easy profits.

The only problem was that the peso was becoming overvalued at 3.5. In the long run, currency rates are determined primarily by the difference in inflation rates between the two countries—a currency is a measure of prices, just as the Consumer Price Index is a measure of inflation. If prices were rising more quickly in Mexico, one would expect the peso to decline in value. For example, if the price of wheat in Mexico were increasing faster than the price of wheat in the United States, people would buy wheat from the United States, and this additional demand for U.S. dollars would make it more expensive, relative to the peso. The same was true of other goods and services. In other words, higher prices in Mexico would put downward pressure on the currency.

During the early 1990s, inflation in Mexico was very high, much higher than in the United States, so there was downward pressure on the peso. However, the Mexican central bank had committed to keep the peso at 3.5 and no lower. Moreover, in 1994, investment funds bought billions of dollars of short-term Mexican government debt, including record amounts of unusual U.S. dollar-linked bonds, called Tesobonos. As a result, the Mexican government soon would need to sell tens of billions of pesos in order to buy U.S. dollars to repay investors, while at the same time the Mexican central bank would need billions of U.S. dollars—to buy the pesos of people wanting to sell pesos at a rate of 3.5. The overvalued peso was a ticking time bomb.

It was unclear how long the central bank would be able to support the peso, but Wall Street analysts—who should have known all of the above facts—continued to issue optimistic reports about Mexico through the end of 1994. Many investors believed the reports, ignored the risks, and continued to put money into Mexico. Their so-called hot money had flowed into Mexico-related funds based primarily on double-digit historical returns, not on any close analysis of the risks associated with an investment in Mexico. In fact, many investors did not even know their investment funds were betting on the Mexican peso. For example,
major U.S. mutual funds—including Fidelity and Alliance Capital Management—owned huge amounts of peso-linked derivatives, including structured notes and options, and did not disclose the details of these risks.
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About 20 percent of Alliance's flagship fund—the North American Government Income Trust—was in peso-denominated debt. As a result, U.S. mutual-fund investors would be the biggest losers from a crisis in Mexico.

Meanwhile, Mexican companies, especially banks, were using new financial techniques to create false profits and to avoid taxes and other regulation. Banco Serfin and Banamex did derivatives deals resembling the Collateralized Bond Obligations invented by First Boston and Salomon Brothers; these deals enabled the Mexican banks to borrow money without recognizing a loss on bad investments. Nacional Financiera, Mexico's state-owned development bank, did an unusual $500 million PRIDES deal with Merrill Lynch, selling securities that in four years automatically converted into shares of Telefonos de Mexico, the state telephone company.
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This deal was very profitable for Merrill Lynch, but made it difficult to understand Nacional Financiera's financial disclosures.

In sum, the financial risks in Mexico were largely hidden from view, and most people were surprised when the Mexican government announced it was abandoning its currency band on December 20, 1994. The peso instantly fell by 15 percent. For a U.S. person investing in Mexican pesos, it was worse than the 1987 stock-market crash. The peso continued to collapse during the following weeks, ultimately dropping by more than half. Investors throughout the world lost billions of dollars. Many Wall Street firms also remained exposed to failing Mexican companies and banks, through loans and derivatives deals, although economist Rudi Dornbusch accused major U.S. banks of “using the back door,” selling off their own positions in Mexico before the crisis, even as they sold peso-linked derivatives to their clients.
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As the peso crashed, U.S. regulators were just recovering from the Fed's interest-rate hike. Secretary of the Treasury Lloyd Bentsen was nervous about another crisis, and was concerned that U.S. investors would panic. He immediately called Arthur Levitt and told him, “I'd like you to close the markets. Don't open them.” Levitt described being intimidated as just “a junior chairman of an agency talking to the Secretary of the Treasury,” but he managed to respond, “Well, that's a very serious step. I don't think that's a very good idea.” Eventually Robert Rubin, former
co-chairman of Goldman Sachs and then chairman of the National Economic Council, calmed Bentsen, and the U.S. markets remained open. Reflecting on the events seven years later, Arthur Levitt said, “A combination of my inexperience, the suddenness of the event, the drama of how Lloyd Bentsen postured this thing made me think about it. I never would have shut the markets down, never.”
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Individual investors did not panic, in part because they did not realize, at first, how much money they had lost. The peso-related losses were just as hidden as the earlier interest-rate-related losses, and ranged from a trader at Chemical Bank, who lost $70 million trading Mexican pesos, to a fund manager at the State of Wisconsin Investment Board, who lost $95 million on derivatives, much of it on trades linked to the Mexican peso. Many manufacturing companies also were hurt by the Mexican peso's decline, which made the goods Mexicans imported from the United States—ranging from auto parts to electrical equipment to children's toys—more expensive. For example, Mattel announced just two weeks after the peso devaluation that it would lose at least $20 million from the peso's plunge.
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