Jamal Mecklai: Never say never again

MARKET MANIAC

I've been getting a new wave of distress calls recently. Rather than from small and medium exporters terrified of the continuing strength of the rupee, this second wave of distress calls is from some fairly savvy treasuries who have woken up to the terrifying weakness of the dollar against, oddly enough, the Swiss franc.

Now, few Indian companies have business exposures in Swiss francs, but, some six to eight months ago, a large number of slightly smart companies jumped at the bait offered by a small number of slightly smart banks, which provided interest savings of around 2% a year on (rupee or) dollar loans by swapping them into Swiss franc. The cost of the swap was defrayed by embedding an option in the product which would require large payments (as a result of the option protection getting knocked out) if the Swissy appreciated beyond 1.11 or 1.10 (or, in one particularly unfortunate case I know, 1.1380) to the dollar. The selling point (other than the interest savings) was the fact that "" till about a year ago "" the Swissy had NEVER strengthened beyond 1.11 to the dollar. That's right "" never.

Well, as even Mr Bond has to all too frequently relearn "" never say never.

On November 9, the Swiss franc closed at 1.1250, and one company I know has already lost USD 650,000 as its protection against Swiss franc strength got knocked out; the real tragedy in this case is that the transaction would have closed out on November 21, and the company would have enjoyed an interest gain of about 80 lakh. Like black magic, this has turned into a loss of about 3 crore.

Another company who had swapped a rupee loan to Swiss franc is breathing heavily since it could lose as much as 5.5 cr if its knockout level "" 1.11 "" gets hit. This was a one-year transaction that still has another six months to run. Of course, it is possible that the dollar could turn around tomorrow "" anything, indeed, can happen "" and the deal would end up profitable. But at this point in time, with the Swissy at 1.1250 and the knockout at 1.11, the risks are enormous.

These are but two stories; I'm sure there are dozens of others who succumbed to the elegantly-packaged temptation of easy money without first checking the real risk of the product or, importantly, assessing how easy it would be to exit from the transaction if things started turning adversely. If they had followed fundamental rules of risk management, chances are that far fewer of them would be in this boat today.

For instance, about eight months ago when many of these deals were struck, the key selling point was the fact that the Swiss franc, which at the time was at 1.24 to the dollar, had NEVER fallen below 1.11. However, what the slightly smart banks neglected to tell the customers and the slightly smart companies didn't bother to find out was that, even given the low volatility of the Swiss franc at the time, the probability of the Swissy hitting 1.11 some time in the following 12 months was "" get this "" around 13%. This means that there was a 13% chance that you could lose a fortune, against an 87% chance that you would make a modest interest gain. Looked at that way, I would imagine far fewer companies would have jumped in with both feet. Further, any strengthening of the Swiss franc (beyond 1.24) would push the mark to market of the product into the red, rendering exit more and more expensive.

Again, given the complex nature of the product, the only exit available would be with the host bank, which would certainly charge its pound of flesh "" business is business, after all. We provide valuations of structured products to some clients and very seldom have we seen bank valuations anywhere close to our theoretical values, particularly when a company is looking to exit.

Of course, pulpits are hardly valuable at this stage. Companies need to find ways to contain the damage. And, while there are no magic bullets, there are structures than can be used to buy time "" deferring the losses in the hope/expectation that the market turns at some point. Another approach would be to defray the losses by selling options, which would in the worst case hit margins on long- term sales but at least eliminate the vicious cash loss on the current balance sheet. This second idea is currently constrained because while the RBI has permitted companies to sell options in the last monetary policy, the we-are-like-this-only process means that operational guidelines are not yet with the banks.

The more important lesson comes from the fact that the structured products market in India has grown faster "" by many miles "" than in any other emerging market. The RBI has been conscious of this and has, from time to time, tried to monitor, control, limit this growth. Of course, it has been unsuccessful, largely because it is not really the RBI's bailiwick to tell companies how to manage their affairs. Rather, it is the job of auditors to inform stakeholders about how the company is managing its affairs. It is hardly a coincidence that till date India is also one of the few markets that does not yet require mark to market accounting of derivatives, which would, of course, render many of these products non-starters.

The Institute of Chartered Accountants is reportedly on the job and expects to have their guidelines on the subject out soon; however, they will be made mandatory only in 2011.

Which, of course, leaves the window wide open for a few more years of more exotic structured product sales, excellent profits for banks, some nice profits for corporates peppered with occasional major losses and late night calls to Mecklai.