Procter & Gamble's Tale of Derivatives Woe - The New York Times
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April 14, 1994
Procter & Gamble's Tale of Derivatives Woe
By Lawrence Malkin
NEW YORK— What is a soap company doing in the swap market speculating with hundreds of
millions of dollars? The cautionary tale of the Procter & Gamble Co., which lost $157 million when
interest rates turned against it, is not the first nor probably the last that will emerge from the great
shakeout of 1994.
Like most multinational companies, Procter & Gamble had been protecting itself against swings in
international interest and currency rates for years by plain vanilla swaps of fixed for floating-rate debt
or vice- versa and occasional use of options, futures, and currency trades to hedge the company's bets.
Wrong guesses meant small losses, usually balanced by small gains when the company was right,
which was the object of the whole exercise.
Late Tuesday, Edwin L. Artzt, the chairman of Procter & Gamble, disclosed that liquidating two
contracts for interest rate swaps cost the company $157 million, $102 million of which would be
charged, after tax, against third-quarter profit. Although not catastrophic for a $30 billion company
like P&G, it was one of the largest ever suffered by an American company - although small when
compared with the $1.36 billion lost by Germany's Metallgesellschaft AG in oil futures trading last
year.
"Derivatives like these are dangerous and we were badly burned," Mr. Artzt said. "We won't let that
happen again."
The swaps were based on borrowed money, which exaggerated market swings tremendously and
meant big money if P&G was right - as it had been on some previous derivative deals. But the two
losing contracts, which were for floating-rate notes in dollars and Deutsche marks, were written
through Bankers Trust Co. on the assumption that U.S. and German interest rates would continue to
fall.
That bet turned sour after Alan Greenspan, chairman of the Federal Reserve Board, announced on
Feb. 4 that the central bank was raising short-term rates for the first time in five years.
But for months before that, Wall Street had been alive with talk that the Fed would change course. It
was only a question of when not whether, and anyone gambling heavily on a continued fall in rates was
riding for some kind of fall, as even high-risk hedge fund managers like George Soros discovered in
February when they lost hundreds of millions.
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Procter & Gamble's Tale of Derivatives Woe - The New York Times
http://www.nytimes.com/1994/04/14/business/worldbusiness/14iht-procte...
As Mr. Soros himself conceded Wednesday in Congressional testimony on derivatives, "the risks
involved are not always fully understood even by sophisticated investors, and I am one of them."
Geoffrey Bell, who runs his own investment company and is executive secretary of the Group of Thirty,
an academic and financial study group, said "P&G's business is toothpaste, not highly leveraged swaps.
It's one thing to hedge, but why were they leveraging up on such a scale? Hundreds of millions more
must have been at risk. How could the chief financial officer not know about something that size?"
Erik G. Nelson, P&G's chief financial officer, told analysts that P&G policy was to deal in "plain vanillatype swaps," and as interest rates rose in February "we started to realize there was an exposure that
those involved hadn't spotted prior to that."
P&G pinned the corporate responsibility on its treasurer, Raymond D. Mains, who has since been sent
on "special assignment." Mr. Artzt also pointed a finger at Bankers Trust and said P&G was
considering legal action against the company.
But Bankers Trust said senior P&G managers had rejected its recommendation to unwind the swaps
weeks ago.
A P&G spokeswoman was unable to say why Mr. Nelson was not taking any of the blame. She stressed
that the transaction was "speculative and goes outside the P&G policy of conservatively managing our
debt portfolio." Asked whether the company's treasury was expected to be a profit center.
So it would appear that Bankers Trust wrote a complex and speculative contract, the implications of
which went beyond the comprehension of P&G's financial officials at their headquarters far from Wall
Street in Cincinnati, and they asked no uncomfortable questions as long as the market was going up
and they were making money.
More shoes probably will drop. "I don't expect they'll be the only company to be hit like this," one New
York banker said. Indeed, Bankers Trust itself, trading aggressively on its own account, lost millions in
the same market turn but understood the risks.
The lesson for those who don't has long been clear. In a speech in December, William J. McDonough,
president of the Federal Reserve Bank of New York, warned that top managements of financial and
nonfinancial companies have a responsibility to understand and constantly monitor derivative
markets when their companies are involved in them.
"People of my generation who are not astrophysicists have to strain to understand these products," Mr.
McDonough said. "To put it simply and directly, if the bosses do not or cannot understand both the
risks and the rewards in their products, their firm should not be in the business."
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