Crikey’s old school mate and flatmate Mr G has worked in all manner of places that do complex currency and commodity hedging and he has some thoughts on the $5 billion lost by Peter Costello on the currency casino.

Do we reserve this same judgement for Peter Costello’s $4.8 billion “hedging” loss?

Also on Monday Costello stated,

1) (The cross currency swaps) were the ALP’s policy

2) They were ALP’s debt

3) The Coalition has paid it back

4) The Coalition has stopped it

Further explanation on point three please.

They may be unrealised but they are real and at the mercy of financial traders across the globe. An old saying goes that markets move where they inflict the most pain, so therefore does the AUD re-test sub US50c levels as the Government has to sell AUD to repay its increased US debt obligations? Or alternatively, will the AUD move higher towards the US52c level, following improved macroeconomic fundamentals?

Who do we blame for this fiasco? The ALP for instigating it? The Coalition for not stemming it? The Australian Office of Financial Management (AOFM) for speculating, sorry, hedging the Commonwealth’s debt with this particular exotic product? Or The RBA governor, Mr Ian McFarlane, who told Costello in October 2000 that “macro-economic considerations could override considerations of profits or losses” in that the early repayments of US dollars would weaken an already precarious AUD? I guess only the RBA governor can override an all-important Treasury benchmark such as the AOFM’s 15% US debt maximum tolerance level. But isn’t this defeating the purpose? Shouldn’t this be set in stone in order to protect the overall portfolio?

As already stated, this latest disaster is the largest, but only another AUD hedging fiasco that has plagued Australian corporates for the last few years as the AUD has plummeted from around US83c at the beginning of 1996 to a historical low of US47.75c in April last year. The amount of AUD revenue foregone in this period is quite outrageous.

Clearly, back in 1989 investment banker JP Morgan did their homework in advising the Government on how to manage its debt at the lowest possible long-term cost? It’s interesting to note that their recently merged partner, fellow gurus Chase Manhattan, have also been huge proponents of the cross-currency swap product, marketing it widely to their Australian clients recently.

After advising to raise funds in the more lucrative US markets, the swap has been utilised to arguably mitigate the corporates debt exposure by swapping PART of it with an exposure in the corporates underlying commodity (e.g. gold). However, although a short-term benefit was gained by paying some interest in the underlying commodity (e.g. gold interest rates have typically been lower than their US counterparts), this was eroded by the grossly larger US interest component not swapped (from the devaluation of the AUD) and further leverage undertaken elsewhere in the corporates portfolio to complete the transaction in the first place.

Like Costello, these corporates also faced rising unrealised losses as their original principle debt amounts rapidly escalated in AUD dollars. Even with the mitigation of the swap on the US debt, as the AUD decreased, commodity prices in Australian dollars actually rose, making the commodity component of the debt also more expensive.

To rub a large amount of salt into a now gaping wound, a large degree of hedging was compulsorily undertaken to appease and entice prospective US investors who demanded certainty with fixed cash flows over time. If nothing else, the banks, once again, made a killing from transaction and consultancy fees, not to mention the huge commission on the exotic hedging undertaken.

Below is a list of the four corporates who I have been involved with who have borrowed in the US and undertaken cross currency swaps in the last few years. It must also be noted that they were all undertaken in higher US interest rate environments! (Eg 1997.)

Normandy Mining Ltd

Servicing its debt was tolerable due to its larger reserve and resource base, but now gobbled up by giant US miner Newmont, who can’t be too happy with the opportunity cost involved with the gold hedging.

Great Central Mines Ltd

Former Joseph Gutnick flagship gold miner locked in at 8.875% in 1998 for US$300 million over 10 years. Although the swap entitled short-term benefits from the exchange of interest rate obligations for a component of the debt, with the devaluation of the AUD, not only did US dollars become more expensive but also, the cost of gold denominated in AUD dollars. Subsequently swallowed up by Normandy which itself dropped $500 million on the deal.

Anaconda Nickel Ltd

A shadow of its former self. Along with a share price that has been one of the worst performers on the ASX lately, news has it that the nickel laterite miner is struggling to top up its reserve account for the amount of its next semi-annual US interest rate payment. Even if an extension can be attained, the wolves are approaching the door.

Centaur Mining Ltd

Last but not least. The former Joseph Gutnick nickel laterite/gold miner is now extinct after borrowing US$225 million in late 1997 at the cost effective rate of 11%! With rising costs, exorbitant management salaries, reduced gold production (with the inevitable closure of the Ora Banda operation) and its Cawse nickel plant behind forecasts, the first formal breach of the Bond occurred in January 2001 when it failed to top up its US interest reserve account. Centaur’s swap interest rate benefits expired in 2002 and if still solvent, would be obliged to find US$12.375 million entirely by itself every six months to service its debt to 2007.

The result now sees some outstanding Australian assets in foreign hands and Australia’s reputation has been further sullied by an estimated $3-400 million loss for the shareholders and lenders.

Perhaps Brian Blythe, Spotless executive chairman, did sum it up best with “The only people who make money out of hedging are banks”.

It seems brains run in the Blythe family. Having known Brian’s son, James, from the Credit Suisse Precious Metals desk, he gave his lucrative sales position away for a temporary life in a Kombi Van, travelling to the hot spots of a European summer.

Peter Fray

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