426 Planning and Forecasting
Toward this end, Procter & Gamble entered an interest rate swap with
Bankers Trust in November of 1993. The swap agreement was far from plain-
vanilla. It most certainly fit the description of an exotic derivative. The swap’s
cash f lows were determined by a formula that involved short-term, medium-
term, and long-term interest rates. Essentially, the deal would allow Procter &
Gamble to reduce its financing rate by four-tenths of 1% on $200 million of
debt, if interest rates remained stable until May 1994. If, on the other hand,
interest rates spiked upward, or if the spread between 5-year and 30-year
rates narrowed, Procter & Gamble would lose money and have to pay a higher
rate on its debt.
Even in the rarefied world of derivatives, one cannot expect something
for nothing. In order to achieve a cheaper financing rate, Procter & Gamble
had to give up or sell something. In this case, implicit in the swap, they sold
interest rate insurance. The swap contained an embedded option, sold by Proc-
ter & Gamble. If the interest rate environment remained calm, Procter &
Gamble would keep a modest premium, thereby lowering its financing costs. If
interest rates became turbulent, Procter & Gamble would have to make big
payments. Most economists in 1993 were forecasting calm. The bet seemed
safe. But it was a bet, nevertheless. This was not a hedge, this was speculation.
And they lost.
The Federal Reserve unexpectedly raised interest rates on February 4,
- Procter & Gamble suddenly found themselves with a $100 million loss.
Rather than lower their financing rate by four-tenths of 1%, they would have to
pay an additional 14%!
Rather than lick its wounds and retire from swaps, Procter & Gamble
went back for more—with prodding, of course, from Bankers Trust. As losses
mounted on the first deal, Procter & Gamble entered a second swap, this one
tied to German interest rates. German medium-term interest rates are remark-
ably stable, and so this bet seemed even safer than the first one. Guess what
happened. Another $50 million of losses mounted before Procter & Gamble fi-
nally liquidated its positions. Losses totaled $157 million. Procter & Gamble
sued Bankers Trust, alleging deception, mispricing, and violation of fiduciary
responsibilities. Procter & Gamble claimed that they did not fully understand
the risks of the swap agreements, nor how to calculate their value. Bankers
Trust settled with Procter & Gamble, just as they settled with Gibson Greeting
Cards, Air Products and Chemicals, and other companies that lost money in
similar swaps.
Metallgesellschaft
Experts are still divided over what went wrong in the case of Metall-
gesellschaft, one of Germany’s largest industrial concerns. This much is cer-
tain: In 1993, Metallgesellschaft had assets of $10 billion, sales exceeding $16
billion, and equity capital of $50 million. By the end of the year, this industrial
giant was nearly bankrupt, having lost $1.3 billion in oil futures.