2008 was a year of financial wonders – Lehman Brothers’ sudden collapse and Volkswagen/Porsche case, just to name a few. Poland had its own local story which burst in the autumn of 2008 and evoked a huge turmoil in the equity market. I am pretty sure that this case will turn up sooner or later in some other market and its remembrance will flash a red light. This is about how the most rational investment decision may turn out to be the worst one. Main characters: the good – entrepreneurs, the bad – banks and complex financial instruments. Sounds familiar?
The origin of the story was the constant appreciation of polish Zloty (PLN) which started when Poland entered the EU in 2004 and lasted for 5 consecutive years. Exporters complained about falling profitability of their businesses and in the face of Poland’s expected access to the eurozone nothing foreshadowed a change in the PLN appreciating trend.
Chart 1. EUR againts Polish Zloty currency (PLN), 2000-feb-2010.
Yet the contrarians won again. In the middle of 2008 we faced a strong reversal in the trend, as bad news started to flow in from all over the world, with Lehman Brothers bankruptcy reinforcing investor flight from emerging markets. During the next 3 months EURPLN went up by 20% and it was then when a middle-sized construction company listed on the Warsaw Stock Exchange (Erbud) announced a large downward revision of its net income forecast due to financial cost increase. A glance at the statement was enough to see that the rise in financial costs erased the company’s entire operating income for the FY 2008. Price fell 37% in one day.
It turned out that the company, intending to protect revenues in EUR from appreciating PLN, used an FX option strategy called collar: long EURPLN, long EURPLN put, short EURPLN call. Assuming hedging 10 million EUR revenues, call strike at EURPLN = 3,0, put strike at EURPLN = 3,5, call premium = 1 million PLN, put premium = 2 million PLN, this is the payoff chart of such a strategy – looks fine, as the company’s revenues are hedged between 29 and 34 million PLN.
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Chart 2. EUR/PLN collar payoff
The problem was, this was NOT the strategy that Erbud employed. Since a put option was more expensive than a call, the company wrote twice more calls than bought puts (to make the structure free of charge). By altering only this assumption, the payoff diagram changes substantially:
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Chart 3. EUR Zloty polish currency (PLN) asymmetrical collar payoff
Erbud did not use hedging accounting so, when PLN crashed, loss from the strategy had to be booked immediately in the income statement as an unrealized loss. Erbud closed the transaction and realized the loss at EURPLN = 3,9 before settlement by going long a forward contract on EURPLN, which turned out to be a good decision, considering EURPLN peaking soon at 4,9. The company management board warned that it was not the only one to employ such an asymmetrical strategy.
So who’s next?
After this event, investors and financial press rushed to search for other companies hiding the poison pill in the form of written FX calls. Nobody until that moment would ever think that depreciation is negative for exporters! Interrogating management boards, banks, scrutinizing footnotes to financial statements – that was what everybody was doing in the market. ‘Puls Biznesu’ (Polish financial newspaper) published entire pages of CEOs’ declarations that they ‘did not enter any speculative option transactions’. I remember myself examining a CFO of a company who didn’t want to disclose terms of hedging strategies mentioned in a financial statement.
Scale of the problem
Erbud proved to be just the tip of the iceberg. As PLN depreciated further (EURPLN rose by 50%!), banks started calling companies for payment resulting from option settlements. And companies were simply unable to pay – losses from written calls exceeded cash reserves, in some cases even total assets. The foolishness of the firms was as amazing as the cunning of the banks. Transactions of triple and more call-to-put exposition took place. Sometimes the position taken in put options seriously exceeded contractual or expected revenues which in the same time were subject to decrease due to developing crisis. Banks, on the other hand, secured their side of the risk by including in the agreements a EURPLN threshold level at which terms were to be negotiated (in case put was in the money – this, of course, never occurred). It appeared that management boards hardly realized the construction of the transactions they entered into.
In total 100 firms listed on the Warsaw Stock Exchange (out of 350 listed) were engaged in so called ‘toxic options’, as revealed an investigation led by the KNF (Polish financial supervision authorities). Several companies went bankrupt, financial situation of plenty deteriorated (cash drain, increase in liabilities, creating provisions, financial losses). Exporters’ financial results for the 4th quarter of 2008 were simply DISASTROUS. Ironically, the ones that should perform relatively the best in times of currency depreciation, were hit the most and proved to be the worst investment at that time. Banks became victims of their own business, too – they were unable to execute all the receivables from the firms so they were forced to accept partial payments, create provisions for bad loans and write off losses. That was, again, visible in income statements and made option selling banks underperform the market. This was also the reason why the whole story was proclaimed to be ‘Polish subprime crisis’.
It’s easy to imagine that the whole affair did not add to sympathy for banks; in fact they were hammered by the press, public opinion and the government. As entrepreneurs felt cheated, they brought actions against banks. Legal advisory for injured companies flourished. The KNF tightened disclosure requirements regarding hedging transactions. Financial institutions holding shares of unfortunate companies decided not to grant discharge to CEOs/CFOs.
The ‘toxic option’ case faded in the middle of 2009 when most of the calls expired. Yet takeovers of the firms which employed the cursed strategies still take place.
The instruments were advertised by banks as “cost-free option strategies“.
Autor of this post: Aleksandra Tomala
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