Following is an epic account of a “Hedge” developed and loved by the banks. This is a national crisis! But what’s the matter ….minor matter…are we worried …NO! Why so? Because, it was the experts of the CBSL (Central Bank) who wanted the Zero Cost Collar structure implemented for the Hedge. With the passage of [...]

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The Sundaytimes Sri Lanka

Heads the banks win: Tails the CPC loses

By Upul Arunajith
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Following is an epic account of a “Hedge” developed and loved by the banks.

This is a national crisis! But what’s the matter ….minor matter…are we worried …NO!

Why so? Because, it was the experts of the CBSL (Central Bank) who wanted the Zero Cost Collar structure implemented for the Hedge. With the passage of time, they even mastered the art of underwriting Bonds (high yield bond!). This newly acquired skill at their disposal will come into their very rescue as we now have to pay these banks who made a mess of a valid mechanism by using a Zero Cost Collar option.

The banks have been awarded almost US $ 250 million dollars by the arbitration panel. This is free money going from the loss-making state corporation to multi-million dollar banks with a strong global presence making huge profits year over year. These banks all seem to be having a recorded history of structuring skewed Derivative deals and then make these a lottery win.

It is not the CPC who has to pay the banks, but it’s the banks who got to pay the CPC.

Expenses vs Losses

The banks did NOT lose money in the hedging transactions. They only incurred expenses when they sponsored vacations for the CPC’s senior officials in particular the number cruncher and the family. As well, ex-gratia payments (santhosams!) made as was revealed during the preliminary investigation were no losses. These payments were made to garner the business from the CPC and influence the management of the CPC. But then the banks recovered those expenses in the first year itself with heavy trading commissions. They even issued a press release that year; they made record profits and made heavy bonuses to the country manager and the staff. Bonuses were in the millions.

It is fundamentally wrong to misinterpret expenses as losses and expect the average man and women to pay for these “losses”.

Dressing up a Corpse

It was reported that the CPC lawyers advised that the CPC negotiate and compromise for a lesser amount to bring closure to the crisis.Did we need a lawyer to advise us to compromise and seek lesser payment to have the matter resolved? This is the most ludicrous comment I have heard. Why didn’t the lawyer give this advice upfront? If they had given this advice upfront the CPC would have saved the interest cost, travel and legal expenses. With this type of ridiculous suggestion, the lawyers retained by the CPC only seems to be having a vested interest in the affairs of the banks and not the CPC. If this matter was not within their skills they should not have taken up the case. Did these lawyers know the bank used a banned Derivative instrument? Having failed in two attempts to successfully present the case on behalf of the CPC, they now try to mitigate damages by making ridiculous suggestions. It is now clear not only the banks but even the CPC lawyers flawed. These lawyers are now trying to “dress up the corpse”!

Reasonableness of the Judgment

Has the amount awarded been verified? When the SCB (Standard Chartered) claimed $160 million and Deutsche Bank claimed $60 million plus accrued interest this amount must be verified and vetted by a technical expert.

Has it been done? If so what has been the formula and the basis? Full and complete disclosure is mandatory. Mark to market valuations, daily unrealized profit and loss reports, assumed exposure management reports and daily values at risk reports must be presented by the banks. Citi Bank pulled numbers from the thin air and when put on the spot, disappeared into the thin air claiming even a high school kid can calculate the swap payment. Deutsche Bank did the same with a German Paper manufacturer and eventually had to pay the client for miss-pricing and miss calculations.

Validation of the amount awarded is critical before moving ahead on this.

Due diligence

If at all in the unlikely event the banks made a loss, the loss was driven by lack of understanding as to what they were doing and because they did not do proper due diligence. No hedge provider will provide a hedge without properly covering their exposure.Hedge providers assume a calculated risk and the assumed exposure is managed.

Banks who dabble in Derivatives are vulnerable to losses. They cover their positions and do not carry unmanaged exposures given the market volatility of the underlying instrument. Exposure management is a critical function of Derivatives trading. The downside risk should have been evaluated and managed accordingly. If the banks did the proper exposure management and analyzed the CPC balance sheet then that would have reflected upfront that the CPC was cash flow deficient to meet payments when it was due. At that stage, the bank should have taken proper steps by way of using OTC instruments to mitigate possible contingencies-a default by CPC. When one-sided deals are structured its bound to go against the target outcome and this has been the case in almost all Derivatives debacles over the years. This was demonstrated with the collapse of Lehman Brothers, Barrick Bank, Orange county, to mention a few.In the case of bankrupt Lehman Brothers, LB ran a leveraged portfolio and failed to do a proper due diligence. Lack of proper due diligence, over leveraging and miscalculation caused LB to collapse.

The same is true with the foreign banks who provided the hedge to the CPC. They failed to do proper due diligence, provided an over- leveraged instrument and also used banned instruments in the hedge.

As well, there was no proper collateral posted by the two parties. Since the leverage zero cost collar structure resulted in the creation of a naked option position, the risk associated was unlimited and that requires a collateral deposit by both parties.

Total lack of collateral, failure to do proper due diligence and mismanagement of assumed exposure resulted in this mess. All these observations must be presented to the bench (court) in a plausible manner for them to comprehend. There is no way how any reasonable thinking bench would award damages in the event the technical observations were presented to the judge in a simple way that is within their comprehension. In the SCB deliberations, I observed the CPC lawyers failed to make a complete disclosure and selective disclosure is counter-productive and misleads the judge.

Tough Call

In the national interest, let us all recognize that the banks are the root cause of this debacle. The battery of lawyers retained by the CPC proved to be no help having lost two proceedings. In a case where the banks flawed, the lawyers lacked the skills, in particular technical skills to counter the fabrication of the banks.

Let there be no debate for there cannot be two things right. The banks when they should have acted in the best interest of Sri Lanka and had a fiduciary responsibility, went off at the tangent and had self-interest ahead of that of the greater nation. As I write and as I always did, I reiterate that there is no need whatsoever for the CPC to make any payment to the banks. No negation for lesser payment as advised by the lawyers. Not unless there is a concealed agenda and patronage from the higher-ups. In every war and crisis, someone somewhere made money and that is yet to be determined. Banks who defrauded every citizen of Sri Lanka by selling wrong instruments to the CPC and by misleading the policy makers should be made to absorb losses. There is no dialogue there.

The banks flawed; then they absorb their flaws!

Arbitration and Ruling:

The right lawyer can lead the bench to give a wrong judgment. CPC arbitration is the living testimony of my conclusion. Even the struggling Citi Bank without any merit was bold enough to throw a “punch” at the CPC to make hedging a windfall. They had no proper basis and they lost the proceedings. The same should have been the outcome of the other two arbitration hearings as well. In the case of the Citi Bank, the bench concluded that there was nothing legal and everything about the trade was wrong. This is based on technicalities. I always mentioned we cannot win the litigation on legal terms. But, then when it comes to technicalities, we have a strong case to fight and win.

In the case of the SCB, one judge called for the annulment of the case. Annulment was precipitated by technicalities. But did I say, the right lawyer can skillfully lead the judge to deliver wrong judgments. Is this a “hung judgment”?

Deutsche Bank

In the case of DB in March 2011 the German courts gave an unprecedented ruling when the bank tried to take legal action against a pulp and paper manufacturer in their interest rate hedging program when the DB sold a wrong OTC Derivatives, Interest Rate Swap (IRS). Sure enough, the DB was successful with the first round of litigation. But the steadfast manufacturer never gave up and eventually won the case as that is the right judgment. The paper manufacturer could have given into to the legal system with no counter litigation. But decided to take on, given the strong basis they had.

The same applies to the CPC-DB arbitration as well. Even the cash-flow directions were all wrong and the hedge was a little more than a mess of maize. The entire country got stranded in this DB structured “Hedge maize”. DB now expects the average citizen to bail out the bank for their oversight.

What is the annual revenue of DB and SCB global operations? It exceeds the annual GDP of Sri Lanka. These banks are making sustained growth in profit year over year and then still they go after a failing state corporation expecting the bleeding CPC to pay for the follies of the bank. Well we know in a dog eat dog corporate world ethics have no place. Then harsh circumstances will make the rules and the CPC has to survive. Banks with a global presence will survive without this “free money” from the CPC.

An entire nation is aware the banks have flawed. The Attorney General has confirmed the deals as illegal. Against this background, as per “legal advice” if the CPC negotiates and makes payment to the rogue banks that will be a betrayal. Every man, women and child will be weeping for they have been betrayed. We will be sending a wrong message to the rest of the corporate world that with the right lawyer they can make the right judgment.

This is free money going to banks to make fat profits and fatter year-end bonuses.

Having lost the litigation against these banks, where do we go from here?

Path of Least Resistance

We can do two things: Taking a path of least resistance CBSL can use our borrowed foreign exchange reserves and then pay the banks as per the arbitration ruling making them happy bankers. Or even better the CBSL can underwrite another round of Bonds (high yield) to pay off the banks and get on with life and pay for the ever increasing oil bills by way of more borrowings because our exports in real terms will decline due to high energy cost.

Failure in our maiden experience in the hedging programme is no reason to discard the entire concept of hedging. Despite the failed attempt, hedging remains a valid concept and more and more corporates have a dynamic hedge programme in place to manage their yields and remain competitive. As a nation if we fail to keep up with the development, we will be left behind in the Asian economic boom. Hedging has to be introduced but done in the proper manner and not be politicised. There are sectors that should remain from politicisation. Petroleum as a sector must remain free from political interference. Taking a path of least resistance the political leadership should not made a policy stand to abolish hedging. This is the wrong decision. The periodic price increases are due to these shortsighted decisions even when the global spot prices drop. Sri Lanka will pay an approximately 15 per cent more than the annual average spot rates due to these decisions made taking a path of least resistance. With a proper hedge programme in place we could have potentially saved 20 per cent on our oil bills. This leaves us a missed opportunity cost of 35 per cent.

The banks are winning not because they are good (competent) but because we are weak. This is clear when the lawyers have to offer advice to compromise for a lesser payment as they lost an otherwise winnable case. I reiterate this case is winnable. This failure is no indication that the CPC matter lacks merits.

History shows that these rulings can be countered successfully. DB and the paper manufacturer is one good example. There is ample empirical evidence to run counter to these rulings and be successful. The key is to be firm.

At all costs this giving away of free money to these banks must be stopped. It conveys a wrong message. An alternative to a lesser settlement would be in the form of a tax write-off over a certain period. Certainly not making any payment.

Let us not be taking a path of least resistance. This is a winnable case, and as the architect of the hedging project, I lately assumed the role that of the crusader. We must be firm and appeal all the rulings based on technical terms. I have written this time and again. I write for the final time.

The CPC is guaranteed of a win based on technical terms. Giving away free money is the wrong solution.

(The writer is a derivatives specialist based in Canada who was the first to broach the issue of hedging – with many Sri Lankan ministers and the Central Bank Governor – as an option to counter rising oil prices)




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