(4 of 5)
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."