01 Jan 2009, Christopher Whittall, Risk magazine
The Comision Nacional Bancaria y de Valores (CNBV) and the Comissao de Valores Mobiliarios (CVM) - the regulatory authorities of Mexico and Brazil, respectively - have imposed more stringent requirements on corporates regarding their disclosure of derivatives positions.
The CNBV demanded companies disclose their derivatives positions by December 15, while the CVM required such information by November 14. Corporates must declare what derivatives they have on their books, as well as detailing their notional values. However, both authorities have stopped short of implementing regulation on the use of particular derivatives.
"The focus of the authority here in Mexico will be the enforcement of the current regulatory framework, and we will make some adjustments in terms of disclosure," confirms Carlos Lopez-Moctezuma, chief adviser to the president of the CNBV. Lopez-Moctezuma also revealed that two Mexican corporates are being investigated for malpractice, and another six companies are likely to be examined.
Over the past quarter, the value of the US dollar has soared, causing colossal losses for Brazilian and Mexican corporates on foreign exchange hedges (Risk November 2008, pages 60-61).
From September 15 to October 23, the Mexican peso sank from 10.7 to the dollar to 13.67. It stood at 13.18 on December 22. The Brazilian real fared no better, plummeting from 1.8 reais to the dollar on September 15 to 2.44 on October 8. The real had risen marginally to 2.39 by December 22.
Central economic forecasts had predicted the peso and real would strengthen steadily against the US dollar. Numerous Brazilian and Mexican exporters looked to put on trades that incorporated this view, in an attempt to reduce the cost of their hedges, with target redemption forwards particularly popular. This product allows hedgers to sell US dollars at more favourable rates than could be attained using vanilla forwards, but the contract knocks out once a predetermined profit has been reached. However, the notional amount of dollars the corporate must sell increases if the exchange rate moves against it and breaches a certain barrier, normally with no limit to the losses that can be accumulated. As a result, the sharp depreciation of local currencies led to huge losses.
As well as forex derivatives, corporates have sustained losses on interest rate swaps and natural gas swaps. The latter were particularly damaging: the active-month natural gas futures contract on the New York Mercantile Exchange almost halved to $5.29 per million British thermal units on December 22 from $9.54 on August 27.
It now appears many corporates entered into these contracts with multiple banks, thereby taking on levels of risk inappropriate for their business models. "It was a game," says Cristiano Medonca, a futures trader at Liquidez, a Rio de Janeiro-based currency derivatives brokerage. "They were trying to earn with the dollar, and got out of focus with the company's product."
Controladora Comercial Mexicana, a Mexican supermarket chain, filed for bankruptcy on October 9 with liabilities of $1.39 billion related to derivatives. In a recent report to the Mexican stock exchange, the supermarket disclosed it had held more than 100 different derivatives positions with eight separate banks.
Aracruz Celulose, a Sao Paulo-based pulp producer, posted losses of $2.13 billion, having unwound 97% of its derivatives positions. The company's chief financial officer, Isac Zagury, has since been fired, and shareholders have agreed to file a lawsuit against him for "contracting derivatives operations above the limits foreseen in financial policy".
Sadia, a Brazilian food company, originally admitted it had $2.36 billion of dollar futures contracts that have since been reduced to $966 million. The company proceeded to fire its chairman, vice-chairman and chief financial officer. Such actions still have not appeased investors, which have filed a lawsuit against the company for misleading them.
"Some of these losses were definitely speculative, meaning they were not linked to a specific asset or revenue in the same tenor when the derivatives contract came due," says Alexander Carpenter, senior credit officer for Latin America at Moody's Investors Service.
Others have also reported losses: Gruma, a Mexican tortilla maker, has unwound positions of $684 million; Cemex, a Mexican cement producer, posted mark-to-market losses of $711 million; and Mexican glass manufacturer Vitro reported losses of $342 million due to derivatives, and is negotiating with counterparties over a potential $235 million in further losses. Corporates insist they took derivatives positions to mitigate risk, but this has not washed with investors.
"If you make big losses in a financial activity, you create a mistrust regarding your risk management and your business," says Michael Ganske, head of emerging market research at Commerzbank in Frankfurt. "If you are a corporate, you should concentrate on your core activity."
"We think corporate governance is the underlying cause of these derivatives losses," adds Moody's Carpenter. "These companies don't have risk management committees - they don't have the right authorisation in place."
Such amendments appear to be under way in some cases. Alfa, an auto parts manufacturer that reported $494 million in forex and natural gas derivatives losses, has since established a risk management body.
Meanwhile, it seems a flight towards simpler products in the short-term is inevitable. "Corporates are likely to change hedging strategies to more vanilla products as local regulatory bodies are extremely concerned by companies' risk management structures," explains one head of emerging markets trading at a US bank.
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