A BLACK HOLE IN THE BALANCE SHEET
When Procter & Gamble Co. announced in April that it would take a $102 million charge for losses on complex derivatives contracts, P&g officials admitted they didn't really understand what they had gotten into. But it's a sure bet that no one was more surprised than investors holding stock in the Cincin-nati company. They had seen only scant mention in the company's financial statements that it was involved with derivatives.
Over the past month or so, there has been a steady flow of reports of derivatives losses, which has provoked a debate over whether corporate financial executives are taking undue risks. Many major corporations, from Colgate-Palmolive Co. to Coca-Cola Co., have derivatives contracts tied to hundreds of millions--even billions--of dollars in assets. In most cases, the use of derivatives on their own or as parts of complex financings enables companies to hedge business risks, boost income from investments, and lower borrowing costs. "Today, you can create anything from any kind of asset," says Arvind Sodhani, treasurer of Intel Corp. "You can either find an instrument or have an investment bank custom-tailor it for you." But in some cases, the use of derivatives can backfire--and the effects can be painful and swift.
That, in turn, is focusing new attention on whether corporations are adequately disclosing their derivatives activities, especially the risks that these activities may involve. One angry shareholder has already sued P&g's top executives over the write-offs. Despite their immense size, derivatives and associated products are almost nowhere to be seen in disclosure documents. They are a kind of shadow world of corporate finance, one almost as large as that of disclosed dealings, to which investors, analysts, and the public in general have little access. "Unless you know deal by deal what exposures a company's taken, you don't know what they are," says Jacob Navon, a senior vice-president at Boston Co., whose group manages $25 billion in corporate cash accounts.
Swaps and caps. Take large swap deals, one of the most common derivatives transactions. They allow companies to restructure their cash flows, shifting, for instance, from fixed-rate to floating-rate debt payments. Most companies reveal the principal amount on which the swap contracts are based. But very few disclose the terms of the swaps and, more important, the fact that some of them may entail sizable credit risks involving the party on the other side of the swap. Linda Bammann, an executive director at New York-based SBCI Swiss Bank Corp. Investment Banking Inc., had a client come to her looking to limit the company's interest-rate cost. She put together a package of 14 different hedges, largely swaps, caps, options and interest-rate collars, to make that possible. But the full impact of these transactions does not appear on the company's balance sheet. To gauge a company's sensitivity to interest-rate and currency moves today, Bammann says financial statements are not enough. "You have to talk to [the company's financial executives]."
Even more obscure are so-called structured financial products, financial instruments with derivatives attached to alter their yield or principal. Because they are packages of complex financial products, they are more complicated and harder to evaluate than straight derivatives. Some companies use structured products for as much as a third of their financings. Yet only a small number of companies provide any details.
Often virtually invisible are structured notes issued by companies, typically as part of their medium-term note programs. Both issuers and buyers of these notes can find them to be very illiquid investments whose interest and principal payments can fluctuate wildly. Yet many companies holding them simply lump them into the cash and marketable securities line on the balance sheet, leaving the impression that they are as safe and liquid as cash.
ample warning? Regulators are now targeting the disclosure issue. The Securities & Exchange Commission is exploring whether corporations are sufficiently warning shareholders of potential losses. The Financial Accounting Standards Board has issued a draft proposal that would increase disclosure by companies. The board will meet with banks, investment companies, insurers, and other corporations in June. The proposal is only "a small step forward," though, according to Jeffrey Mahoney, assistant project manager at FASB. "Our draft covers some very simple exposures we believe companies have been keeping track of internally," he says.
Many large corporations devote considerable attention to managing their derivatives exposures. But others sometimes get in over their heads when they use derivatives products, as the spate of write-offs of losses over the past couple of months suggest. Regulators argue that requiring companies to disclose more information might cause them to stop and consider whether the transactions are too risky.
Even companies with a good reputation for disclosure report few details about their use of derivatives. Consider Colgate-Palmolive, an active user of swaps, at least one of them having a term as long as 30 years. The company's annual 10-K report and its report to shareholders reveal that about a third of its debt has interest-rate or currency swaps--or both--attached. Colgate says that its contracts are with high-quality companies. Still, its financial reports contain no mention of the credit exposures that those swaps create. And there is little discussion of these contracts, even though Colgate, like every other company, provides much detail, such as maturities, about its conventional debt. Colgate's level of disclosure on derivatives deals is quite typical of most major companies. Says Colgate Treasurer Brian J. Heidtke: "The accounting in this stuff is still underdeveloped, to say the least."
Intel is another case in point. It provides a broad description of its use of derivatives in its annual report. It even talks about its credit exposure on derivatives. But Intel does not reveal the degree to which it makes sophisticated use of derivatives and structured financial products to boost the yield on its multibillion-dollar cash account. Treasurer Sodhani refuses to say what he earns on the company's investments, and he will not discuss some of his current financing plans out of concern that other companies will pick up on them. "We do some things that nobody has yet discovered," he says.
perc performance. Intel's financial strategies are highly complex, if the company's past money-management practices are any indication. For example, Intel has made it a practice to buy PERCs, a type of convertible preferred shares issued by many companies in recent years. Intel would short the issuing company's common qtock, buy a put on the stock at the conversion price for the PERC, and wind up with an asset whose principal was fixed and whose yield was high.
A significant part of the controversy surrounding disclosure concerns structured notes. Experts say close to $50 billion in structured notes was issued by companies in 1993 alone--and institutional investors of all kinds have purchased them. Boston Co.'s Navon says about 15% of the assets his group manages are in structured notes. The notes' returns can be extremely hard to predict. One typical structure: a 11/2-year note where the coupon payments are set at some fixed rate minus the German interbank loan rate. Such a note, with the payments equal to the reverse of some variable rate, is known as an inverse floater, and the coupon rate on that security can abruptly fall to zero if market rates rise.
Financial reports aren't very helpful in gauging the risks of such transactions. Issuers typically say little if anything about their outstanding structured notes. And many companies that buy structured notes as a way to earn high returns on their cash accounts simply include them in the "cash and marketable securities" line on their balance sheets.
Some companies are reluctant to disclose derivatives dealings for competitive reasons. They usually include companies that have set up their treasury departments as profit centers. Profit-oriented corporate treasurers typically feel that if they were forced to reveal details about how they are making money exploiting inefficiencies in the market, others would jump in and copy the trade, and the profits would eventually disappear.
There are, however, a few companies that have been very outgoing about disclosing their derivatives transactions. One example is CIT Group, the Livingston (N.J.) leasing company owned by Chemical Bank and Dai-Ichi Kangyo Bank. CIT, whose stock is not publicly owned, says little in its annual report. But its 10-K filing, which covers two publicly traded note issues, describes in detail the effect of the company's use of swaps and structured products. The disclosure includes its weighted average interest rate on fixed-rate and floating-rate debt with and without the effect of swaps. It also reveals the length of the contracts and the currencies to which CIT is exposed. Says Chief Financial Officer Joseph J. Carroll: "We are publicly owned from a debt point of view, and we feel people have a right to know what we do."
CIT Group is an enthusiastic user of structured products. It is strict about using derivatives only as hedges, according to Corinne Taylor, senior vice-president and treasurer. CIT has a 2% limit on risk: If the company's net interest margin is $500 million, it won't do anything that would put more than $10 million at risk. "We don't take bets--ever," she says. But when it comes to using structured financial tools to cut costs, CIT is aggressive.
Risk free. A recent transaction typifies CIT's creative but relatively risk-free use of structured products. The company borrowed $25 million for two years at 22 basis points over the two-year Treasury bill rate using a structured financing, a rate 18 basis points lower than it would have had to pay to simply borrow at a fixed rate. To get the low rate, CIT first borrowed $25 million from an investor and paid a rate of 13.5% minus the three-month Italian interbank rate, which is variable. Then it entered into a swap with Chase Manhattan's securities subsidiary in which CIT paid Chase fixed-rate payments equal to 22 basis points over Treasuries, while Chase paid CIT variable payments at 13.5% minus the three-month Italian interbank rate. In effect, CIT passes along to the investor the variable-rate payments it receives from Chase. CIT does not disclose this particular deal in its 10-K, but it does describe in detail a hypothetical medium-term note issue that resembles this financing.
Also relatively forthcoming is Coca-Cola. While the company does not discuss its credit risk from derivatives, it does describe its approach to hedging and its losses from hedging.
The Atlanta company is an active user of complex financial products, however, a fact that is not readily apparent from its public disclosures. Coke started formal risk management in 1980 when foreign currency and risk-management functions were combined. In 1986, it started using swaps and in 1988 became one of the first corporate users of options. In its 1993 financial statements, Coke reported that it lost $29 million (pretax) mn hedges. But the company added that the loss was offset by gains on the instruments being hedged.
Some banks and thrifts are being required to disclose more than they once did about derivatives transactions. First Union Corp. in Charlotte, N.C., provides several pages of discussion of derivatives usage in its 1993 annual report, for example. Greater disclosure by banks is warranted, say regulators, because problems at banks can have a wider impact than those at corporations. Comptroller of the Currency Eugene A. Ludwig, has called for a closer look at banks' use of so-called exotic derivatives. He points out that if a corporation loses money, it has to deal with unhappy employees, but if a bank loses money, it is directly connected to the payments system, and its problems can spread rapidly. And problems are clearly possible: Ludwig describes a bank with less than $200 million in assets that has a structured note in its investment portfolio whose interest rate is tied to the performance of the Deutschemark and the Spanish peseta vs. the dollar. Says Ludwig: "We are not convinced that they have this instrument for legitimate hedging purposes or that they understand it." The initial interest rate on this note was 9%, but it is currently paying no interest--and it has lost 20% of its market value.
Many companies put derivatives and other structured products to good use. Indeed, many would find themselves with more risk if they did not use the complex products to offset their exposures to fluctuations in currency and exchange rates. Rather than try to limit what they reveal, the growing number of companies that use derivatives would do well to inform investors of the risks--and virtues--of their new strategies. If not, and if P&g's problems are mirrored elsewhere, they run the risk that regulators will make harsher demands.TABLE: HIDDEN RISKS
WHAT COMPANIES DO . . . . . . AND WHAT THEY DISCLOSE
Companies use swaps, which often last Many companies reveal only the for many years at a stretch, to restruc- principal amount underlying the ture their cash flows. Often, these swaps swaps they use. They rarely
expose them to sizable credit risk. describe the terms and riskiness of the swaps.
Some companies use structured financ- Companies usually disclose little ings for as much as a third of their about structured financings other borrowings. They can be volatile and than the principal amount under- may expose the company to large risks. lying the arrangements.
Companies have issued billions in Companies often say virtually noth- complex and often illiquid structured ing about these complex investments. notes whose interest payments They tend to be lumped into the and principal can fluctuate wildly. cash account on the balance sheet.
DATA: BUSINESS WEEK
Kelley Holland in New York, William Glasgall in New York, Maria Mallory in Atlanta, Rick Melcher, with Greg Burns in Chicago