Read, discuss and answer the questions that follow:
Case Study 2: Procter & Gamble & others
Corporate financial managers are generally thought of as models of caution, paid to
manage a company’s finances prudently and conservatively,. But recent events at Procter
& Gamble, Gibson Greetings, and Metallgesellschaft, a major German company, have
shaken that image. Each of these companies incurred huge losses on derivatives
transactions which were supposedly undertaken to reduce risk.
A look at how P&G got into trouble with risky derivatives shows how tempting it can be
for a company to try to magnify its returns, but how difficult it is to predict the risks
involved. P&G profited handsomely with derivatives in the early 1990s. Sensing more
opportunity for gain, the P&G treasury staff asked Bankers Trust to create a derivative
whose returns would depend on both U.S. and German interest rates. Bankers Trust,
perhaps the most aggressive, dealer in exotic securities gave P & G three choices. P & G
choose the most aggressive gave the derivative that promised the greatest reward but
entailed the greatest risk.
The transaction involved two complex swaps. P&G was allowed to issue floating rate
debt at a below- market rates, but, in return, the company had to give Bankers Trust a
series of “put option” that gave the bank the right to sell to P&G U.S. Treasury bonds and
German government bonds at a fixed price. If interest rates in both countries were
constant or fell, there would be no problem for P&G – the bonds would be worth more,
on the open market that the fixed price, so Bankers Trust would not require P&G to buy
them. But if rates rose, P&G would have to buy bonds at above- market prices.
Rates climbed rapidly after the deal was struck, causing bond prices to plunge, so P&G
was saddled with a rising liability to buy bonds at above market prices. Bankers Trust
said that it advised P&G to cut its losses by closing out the transactions, but P&G
wouldn’t budge. When the first losses hit, the P&G folks who se the transaction up
probably said, “Oh-oh, we have a problem. But let’s wait and see what interest rates do
before we tell the boss.” By the time P&G bit the bullet and closed out the position, it
had a pre-tax loss of $ 157 million.
P&G contended that it was victimized by Bankers Trust, and it sued, contending that the
bank did not disclose all the risks involved in the transactions. Said a P&G
spokesperson, “These transactions were intended to be hedges. We use swaps to manage
and reduce our borrowing costs, not to make money. The swaps turned out to be
speculative transactions that were highly leveraged and clearly did not fit our policy.”
On the other hand, Bankers Trust claimed that P&G is a sophisticated company and that
it knew the rules of the game. The lawsuit was finally settled after more than two years
of haggling, with Bankers Trust agreeing to cover about 80 percent of P&G’s losses.
However, derivatives use and abuse has continued to be one of the hottest topics in the
financial press.