They’ve caused an international Eastern European meltdown alert. But just how widespread was the sale of “toxic fx options,” as they are fast becoming known?
Just to reiterate, fears about eastern European exposure to fx started off with concerns about retail-based fx denominated mortgages. The fear then spread to corporates, regarding their borrowing in foreign-currency denominations.
Now it’s transpired – in the case of Poland – that there was another even more speculative element to the country’s fx exposure: the practice of selling fx options by small and medium-sized corporates for pure profit and not for hedging of fx-denominated loans. This was done mainly by exporters, but not (we assume) exclusively.
What has also become clear is that Polish banks advised these corporates to sell these options because at the time they were seen as no less than a sure-bet on account of the ‘inevitable’ appreciation of the zloty ahead of its moved into the ERM 2 mechanism.
The banks that bought these call options from their corporate clients, meanwhile, then re-sold them back into the wholesale market at a nice profit.
So what went wrong?
Well, the zloty’s plunge shifted the options increasingly into the money, or to be clear quite dramatically into the money. Corporates, which had simply expected their options to expire unexercised, have suddenly been faced with mass payouts.
While many businesses will be able to just about afford the losses, many (especially export businesses) won’t. Some — already under pressure from from falling export revenues due to a recessionary Europe — will undoubtedly be forced into bankruptcy as a result of the toxic securities.
All of which is panicking Poland.
On Wednesday the gravity of the problem led the finance ministry to intervene in the fx market for the first time since the recent depreciation.
More worryingly, deputy prime minister Waldemar Pawlak signalled on Tuesday he would be prepared to back a bill that cancelled the derivative contracts or at least allowed companies to walk away from them. This, of course, would do more harm than good to Poland’s reputation and economy.
It also wouldn’t solve the problem of toxicity in the market place, as the banks which bought and resold the options would still be liable to payout to their specific counterparties. It’s a whole new sort of toxic write-down.
Which brings us to this:
What is it? An advert by a Polish legal firm, which translates to: “Have you lost out on fx options? We offer advice on how you may be able to restructure the terms.”
Robert Nogacki, an attorney-at law at the firm, is therefore quite well placed to give us a little perspective on just how widespread the practice of selling fx options was, and who was really at fault.
He told FT Alphaville the following:
Derivative instruments like forwards, options or swaps for years were used by Polish importers and exporters to hedge currency risk. The distinctive feature which appeared on the Polish derivate market in 2008 was a very aggressive direct marketing of banks targeting entrepreneurs, aimed at selling derivative instruments to clients without appropriate experience and knowledge. In most cases entrepreneurs were talked into purchasing very risky instruments, which did not match their needs arising from core business activities. Most of banks operated with use a very similar pattern, selling speculative derivatives which have assured profits to banks in case EUR and USD gains strength. This actions was followed by sudden weakening of the Polish currency, what has caused a lot of speculation, whether it was intended or just a coincidence.
As far as how widespread the practice was, Nogacki says:
Assuming from the number of entrepreneurs, who reach our office, it’s a huge problem, which can have a significant impact even on GDP of Poland.
Hmmm, subprime deja vu anyone? Furthermore please also note the date. This was happening in 2008 when the lessons of the subprime crisis were already well known – ie. what the perils of structuring agreements with people who don’t know any better are.
Accordingly, Erin Brokovich Nogacki believes Polish firms may have a bit of a legal case to stand on. Of course it will be on a case-by-case basis and the firm is still evaluating the possibilities, but he says in his case:
Most of our clients were misinformed. It shall be up to court to decide whether it was intentional.
Related links:
Another eastern European meltdown? – FT Alphaville
5 reasons to remain bearish on CEE - FT Alphaville