Even though the dollar seems destined for a considerable fall (depreciating the currency is part of the “reflate” remedy that Bernanke is putting into action), it is all too easy to forget John Maynard Kenyes’ dictum, “The market can stay irrational longer than you can stay solvent.” But in this case, the lesson may be simpler. Companies should stick to their knitting and not act like speculators (at least, any more than the nature of their business requires them to be)
It appears that a number of private sector players made what they thought were surefire bets against the dollar that came a cropper. And with extreme moves in short periods of time, the losses have been much larger than even the conservative would have anticipated. Worse, in some countries, enough companies made this sort of wager gone bad that it is going to hurt economic growth.
From the Wall Street Journal:
As global stock markets have plunged in recent months, so has the value of almost everything else, from Mexico’s peso to the price of oil. That’s left some companies that made big wagers on the direction prices were headed reeling from unexpected losses.
Throughout Latin America, companies are telling investors they have lost millions, in some cases billions, of dollars due to foreign-exchange gambles that, in some cases, had little to do with their core businesses.
Losses from bad-currency bets are ricocheting through the world’s major developing economies, including India and Korea. Officials at Citic Pacific Ltd., a Hong Kong-listed conglomerate backed in part by the Chinese government, have accused the company’s finance director of making unauthorized bets related to the Australian dollar, resulting in nearly $2 billion of foreign-exchange losses.
For now, however, such losses appear to be most widespread in Brazil and Mexico. In Brazil, the growing list of blue-chip casualties includes paper-pulp giant Aracruz Celulose SA and industrial conglomerate Grupo Votorantim. In Mexico, trading in tortilla maker Gruma’s stock was halted earlier this month after its potential losses mounted to $684 million.
The surprise disclosures have sent stock prices tumbling, and regulators in both countries are investigating whether companies adequately disclosed their trading risks to investors.
Some local reports have speculated that the damage in Brazil alone could exceed $30 billion and may affect two hundred companies.
“We really don’t have the details yet, and it’s definitely not clear where the losses are. There are a lot of transparency issues,” says Alexander Carpenter, senior vice president for Latin America at Moody’s Investors Service, which has issued a flurry of credit downgrades and warnings across the region.
The bad bets were made using currency derivatives — contracts tied to the value of the U.S. dollar. Companies lost badly when the dollar shot up in value starting in early September as investors cashed out of investments in emerging markets, fleeing to safer havens. And as companies raced to close out their positions they forced local currencies to tumble still further.
Latin American central banks, seeing risks to their economies, sold billions of dollars from their reserves to currency markets to prop up their currencies and cushion the blow from derivatives losses.
Mexico alone burned through about 13% of its international currency reserves. Brazil’s government is considering extending loans to affected companies.
“The companies that bet and lost will have to face up to their responsibilities,” Brazilian President Luiz Inácio Lula da Silva said recently as corporate losses mounted. “Obviously, what Brazil will always be disposed to do is create conditions so that the financial system can lend.”
In Mexico, authorities said they are investigating whether Comercial Mexicana and other companies properly disclosed the currency bets that resulted in investor losses. Under Mexican law, failure to disclose certain transactions could result in fines, and in some rare cases, criminal charges…
Some bankers predict the losses will prove manageable. Marcos Lisboa, executive director of risk and internal controls at Unibanco in Brazil, said there are problems “but nothing like the order of magnitude people are worried about.”…
Companies appear to have been lulled into making risky bets, perhaps without fully understanding them. Both Mexico’s peso and Brazil’s real have strengthened steadily against the dollar in recent years, thanks to high commodity prices and record foreign investment. Few thought a turnabout was likely.
Executives at Comercial Mexicana, whose stores sell digital cameras, TVs and other imported products, had protected itself against exchange-rate fluctuations by buying up dollars on futures markets. But, in recent months, with the peso’s continuing rise, that insurance proved costly.
So, starting during the summer, Comercial Mexicana’s treasury department stopped buying dollars as insurance and instead began laying bets against the U.S. currency, according to people familiar with the matter.
“They got into a comfort zone, and tried to make money on the appreciation of the peso,” says Nicolas Olea, an executive with KPMG in Mexico City.
The retailer, along with other companies, made the bets using currency contracts sold by big banks, including J.P. Morgan Chase & Co. and Barclays PLC, both of which declined to comment.
Under the deals, the banks offered financing and currency trades at favorable rates. But there was a hitch. If the U.S. dollar strengthened beyond a certain threshold, then the companies would have to sell dollars at a loss. In some cases, the contracts had triggers that doubled the number of dollars the companies owed.
Comercial Mexicana purchased the contracts from five different banks. At first, the deals were profit makers.
But when the company’s finance chief, Francisco Martinez de la Vega, returned from a two-week European vacation on Oct. 1, he found a situation spiraling out of control.
By then, investors panicked over the widening financial crisis had begun pulling money out of Mexico and other emerging markets. Since Aug. 1, the peso has dropped 24% against the dollar, and in October careened through its biggest daily drops since a 1994 currency crisis.
Comercial Mexicana suddenly faced huge losses. Mr. de la Vega had to call in bankers from Credit Suisse over the weekend of Oct. 4 to help him analyze the situation. The total cost to close the position: $1.4 billion.
Later that week, Commercial Mexicana filed for bankruptcy, unable to pay the debt. In a note released to markets, the 76-year-old retailer said it would seek to keep its 221 stores in business.
“Operating fundamentals are the most solid they have been in several years,” the company said.
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The kinds of price swings we have seen globally this year are extraordinary, and concepts of risk haven’t kept pace. Look at wheat; oil, $ down, now $ up, soon $ ??. This is what the onset of chaotic disequilibrium looks like. A major rivet point node in the global financial economy is shredding: the dollar. We will only stability when the system reconfigures with a different stress distribution, which all but inherently means a different weighting for the dollar. Everyone’s money and experience are tied up with where the dollar was, not where the dollar is going, and the transition will be anything but smooth. Why do I keep feeling that at some point a key value in this system goes to zero for a time?
Richard: I call this “the martingalian man” – tomorrow will be the same as today (or, at worst the same as yesterday).
What I find fascinating is that these would-be speculators tend to get hit both ways. First, they bet goes spectacularly wrong only to be proved right few days/months after their run out of money/their costly hedge expired.
Volatility kills.
some anectodal evidence from having spent a year working on the latin america credit structuring desk of a big investment bank in new york last year.
a lot of latam exporter companies entered into currency derivative transactions as a “hedge” for their business. structurally, these companies are long dollars through their business, as their export earnings are in hard currency, but their cost base typically in local currency. so it made sense for them not only to borrow in dollars, but also to overlay that borrowing with a currency derivative in which they shorted the dollar even more.
unfortunately, these companies overlooked three rather important points:
– a lot of the derivatives they traded were way too leveraged. in particular, they often traded “one-touch” transactions that would lose them a lot of money with a temporary spike in the dollar, whereas their business benefits only with a sustained dollar rally.
– they did not consider that a dollar rally would be associated with a global recession and therefore a fall in the volume of exports and therefore a fall in dollar revenues.
– they did not think about cashflow implications – i.e. the derivative loss may need to be paid upfront, whereas the benefit of a stronger dollar will be realised only over many months.
more worryingly, i am also aware that one of our competitors specialised in providing “dual currency” loans to less sophisticated medium sized companies, especially in brazil. i believe these loans run into the tens of billions. the currency derivative embedded in these loans typically generates a huge one-time loss to the borrower if there is a sudden move in the dollar / real exchange rate. the reason for these brazilian companies to enter into these loans was because they offered a superficially very low interest rate (i.e. unlike with the big exporter companies, it had nothing to do with hedging). i would expect a lot of these smaller companies to get blown up by these loans in the current market environment.
moreover, given that they were nearly all arranged (and i believe the currency risk internally managed) by that one big competitor investment bank i mentioned, i would expect that investment bank to potentially face very big credit exposures as these brazilian borrowers prove incapable of meeting the big one-time payments now due.
Why is it these stories are always about forex losses? By its nature, any forward, futures or derivative contract has someone on the other end. Why not a story about “… making unexpected forex gains”?
Any move in currency is going to have some winners, some losers. Why are the losers news?