Hedging is a complex business and we’re getting loads of feedback after a Terry McCrann article claiming tens of billions have been lost by exporters which failed to lock in a low dollar when it was down in the 50s.
Terry McCrann had one of his best columns in a long while on February 12 as he nailed the huge hedging blunder which has cost Australian exporters, taxpayers and shareholders tens of billions of dollars.
It is so neatly presented that we’re reproducing his first six paragraphs as follows:
“Australia’s resources sector is presiding over a multi-billion dollar foreign exchange disaster that makes the NAB’s loses look like petty cash.
It is also a hidden disaster – it will never actually be revealed in rivers of red ink. But it is there to be ‘seen’ as companies unveil their interim profits like WMC Resources did yesterday.
It is hidden because it’s what companies did not do with their US Dollar export earnings. It can be ‘seen’ by the absence of having ‘done’ something.
The disaster, put in place progressively since 2001, and now really starting to hurt, is the exact reverse of the disastrous practices that stripped billions of dollars from companies like WMC and Woodside and certainly bankrupted Pasminco.
Then, it was the mistake of locking in high $A-$US exchange rates for revenues through hedging. Now it’s the failure to lock-in the low $A-$US exchange rates of 2001.
A failure, driven almost entirely by that earlier experience. And a calculating decision by boards and managements that while you can and will be hung out to dry by that things that you do do, you can’t and largely won’t be held to account for things – hedging – that you don’t do.”
End McCrann quote
The Australian dollar hit fresh six and half year highs of almost US79c today making all those exporters who failed to lock in hedging in the 50c look rather silly.
There is a standard question that journalists should be asking at all these profit press conferences at the moment: “Why didn’t you lock in future export and foreign earnings when the dollar was down in the 50s?”
Last time we raised this issue all these financial and corporate types came back with comments such as “you’re a genius with the benefit of hindsight” and “you can’t attack someone for not hedging”.
Crikey stands by the argument that the once-in-a-generation dive to US50c was obviously not a long term proposition when assessed using purchasing power parity, economic fundamentals and historical trends. Blind freddy should have been able to see this.
Companies which had a no hedge policy all the way through have a reasonable argument because they raked in the profits during the down years. But companies such as Woodside, WMC Resources and BHP-Billiton which abandoned disastrous hedging policies on the way down should be firing the finance director – or the board members who rejected the hedging proposals put up by management.
This has cost Australia tens of billions of dollars. Who is being held responsible.
The only qualifier is the argument that banks were already fully hedged themselves and it was literally impossible for companies to buy upside protection for a reasonable price.
This may need to be explored further but companies like Westfield America Trust have done a great job locking in at US57c. If Frank Lowy could get it right, why couldn’t all the establishment companies run by the directors club?
Once again, please send in your contributions to [email protected] as this is a complicated argument but one that deserves to be fleshed out in great detail give the size of national wealth at stake.
How banks ripped everyone off with a low dollar
As the dollar breaks through the US79c today, a forex professional writes:
Sadly, the true story about the great Australian hedging fiasco is quite simple.
The banks have the opposite exposure to the miners. They borrow predominantly in $US and lend in $A, so they are exposed to a weakening $A. The miners exposure is to a rising $A as they get paid in $US and spend in $A.
So, being smarter than your average bear, the bankers insist that the miners “hedge” their exposure to a rising $A. This miner “hedging” is in fact a way for the bank to get paid to cover their own risk. The banks strategy is easily put into place, because any junior mid ranking miner loves to get a board member from a big bank involved (Mark Rayner, Jerry Ellis, Don Argus etc).
This banking strategy worked flawlessly in the late 90s and early 00s – in fact it is fair to say that it worked too well in the case of Pasminco, as the company eventually folded and left the banks with a basket case company on their hands.
Ever wondered why the Australian banks never complained about the weak $A?
Fonzie Forex a complete goose
Gosh, Stephen, what twaddle your correspondent Fonzie Forex gave you on Friday. Was he or she at home pending the outcome of the NAB options investigation?
The banks are not “exposed to a weakening $A”. Have you ever heard a bank CEO explain its improved profits in terms of a high $A or losses due to low $A? Of course not. When the banks borrow in a foreign currency, they hedge the proceeds into $A. This is basic balance sheet management, and banks do not take foreign exchange risks in their borrowing and lending activities. This part of banking is an interest rate spread business, not forex risk.
Obviously, this needs to be differentiated from foreign exchange trading, where views are taken by dealers on the likely direction of the currency, and bets are made accordingly. In this case, banks want the $A to rise if they buy $A and fall if they sell $A, but there is no automatic exposure to a falling $A.
As for your response to Fonzie, “And this might explain why the Australian banks were unable to offer attractive upside hedging protection when the dollar was in the 50s.” Where does this view come from? Are you trying to say that when the $A was 50 cents, bank Treasury operations stopped writing forex options for hedging purposes. Must have been a few dozen forex dealers out of work for a couple of years. Of course the miners could hedge if they wanted to. They did not hedge at 50 cents for the same reason they did not hedge at 70 cents and 60 cents on the way down. They were waiting for it to go lower, and then it is too late.
The mining company CFO who hedged at 65 cents was probably sacked by the CEO and Board when the $A reached 50 cents, rather than being a hero when it went back to 80 cents. There’s a joke in the forex market about trying to pick bottoms, but I’d better leave it out.
I believe Fonzie is a character in The Muppets. Explains where the forex training came from.
(And you can identify me on this if Fonzie wants to enter a correpsondence).
Fonzie forex hits back
I may well be a complete goose, but maybe Graham should read the initial post again, as he might find that he is arguing himself into the barnyard to join me.
Of course the banks hedge their exchange rate exposure.
(Not wanting to nitpick, but the banks don’t want to “hedge the proceeds into $A”, they want to sell future $A revenue to repay future $US debts).
As anybody who has ever been involved in a broking business will tell you, this can be achieved in several ways.
In this case, the banks could “hedge” their exposure, as Graham suggests, buy going to the market and buying the $US forward.
This would involve buying at the high end of the bid/ask spread. The smarter way is to get somebody else to sell you $US at a fixed rate, because then he pays the bid/ask spread, and commissions, and establishment fees, and credit checks, and margin calls, and every other cost the bank can roll in.
This way instead of your “hedging” costing money, it becomes a revenue stream.
Music to a banker’s ears.
If Graham truly believes that NAB or any other Australian bank pays to cover their entire $US/$A risk at one end of the spread while their own currency desk holds the opposite risk – he should go back to watching the Muppets.
PS – for what it is worth, I also disagreed with Crikey’s
There was plenty of opportunity for miners and others to buy $A forward at around 50c, but our skittish board room heroes followed the “once bitten – twice shy” formula for long term job security.
PPS – sorry to appear wimpy, but would prefer to remain anon in this debate.
Some companies concerned are clients of mine, and my views definitely do not reflect those of my employer.
Plenty of upside hedging available
I am writing (anonymously please) on the question you are raising about FX hedging. I work on the FX options desk at a major Australian Bank (no not NAB, but I did work there and do know the traders reasonably well) so I have some knowledge of how this market works.
The contention that banks were not offering companies the opportunity to take upside hedging could not be further from the truth. In fact so convinced were most banks that the currency was going to fall well below 50c that it was the price of downside hedging that went through the roof.
There is a liquid traded contract called a ‘risk-reversal’ which is essentially a directional hedging tool. This contract reflects the directional bias of currency markets. As AUD fell below 50c this contract had its strongest ever bias for downside protection. So banks were falling over themselves to buy downside protection and sell upside protection
The AUD options market is extremly liquid and deep and ceratainly able to deal with the volumes of Australian corporates (in fact the volume of AUD traded by Australian corporates is but a small fraction of the total volume turned over every day. Banks would have no problem dealing these amounts)
Nothing I have written is sensitive information but I am not an official spokesperson for my Bank and reiterate that I wish to remain anonymous
Two classic case studies of miners stuffing up
Mining insider writes:
I haven’t read the Terry McCrann article yet but was wondering if this has anything to do with diabolical hedging positions of two ex-mines a few years ago when commodity prices and $A went south at the same time due to overvalued US$.
Pasminco (with profitable Century mine) and Western Metals (Gunpowder Mine) in 2001-2002 hedged A$/US$ exchange rate probably in the area of 65c and were locked in when exch rate tumbled to 48c at one stage – thus these producers were missing out on favourable exch rate and were probably forward selling commodity prices such as gold US$280oz and copper US 65c/lb. Price of gold drops to US$245 oz and exch rate down to 48c, the Australian Federal Reserve sells its gold reserved at the bottom of the market, this all puts Pasminco and Western Metals in some trouble and the banks called in the receivers and probably got 20c in the dollar back and left all the shareholders with Pasminco and Western Metals toilet paper. NAB and Bank of Western Australia.
Since then the A$ zoomed up to 78c starting in late 2003 and the price of gold up to US$400+ oz and even Cu to US$1.10 lb with commodity price rises outstripping the increase in value of the A$.
Interestingly Bank of WA outsourced credit risk group but now terminated contract and doing it “in house” again. Gunpowder mine sold lock stock and barrel for pocket money $4M (?) then new owner sold the SX-EW plant to MIM/Xstrada for $40M a few days later. Similar story 3 yrs ago when banks put Aust Resouces into receivership and sold Selwyn Mine to new float
Selywn Resources for $3.5M (trouble was – when the mine was shut there was about $3-4M worth of ore on the deck “ready to go”.)
Brilliant in hindsight
I hate to agree with the “all these financial and corporate types”, but you are playing the genius with hindsight. I disagree that blind Freddy could see that a US50 cent Aussie dollar is obviously not a long term proposition. The currency markets in my experience are completely unpredictable. 50 cents may look cheap, but at the time, could anyone have confidently predicted it wouldn’t be 40 cents 12 months into the future?
Purchasing power parity is a fine theory and probably works out ok in the very long term, but there have been, and continue to be, instances of currencies being out of whack with PPP for extended periods of time. The Aussie dollar has probably been undervalued against PPP for decades (perhaps there are some economists in your readership who can provide some facts on this…).
This is the trouble with PPP is that it doesn’t say anything about when currencies will move to the “right” level.
If you’re putting a hedge in place, you may hedge a large proportion of 6 – 12 months of sales, a lesser proportion of say 12 – 24 months worth of sales, and perhaps nothing or negligible beyond that. If you’d locked in the 50 cent rate and then had to deliver on it 6 months later, the rate could well have dropped to 45 cents in the meantime and you’d be out of pocket. Knowing that the exchange rate will eventually correct itself isn’t all that helpful in the real world.
Now, where corporates can be criticised is the form of hedging undertaken. Generally this appears to be done through forward rate agreements, where the company contracts to deliver a fixed amount of USD at a fixed point in the future at a fixed exchange rate. The company doing the hedging is obligated to deliver the USD regardless of what the exchange rate has done in the interim.
This works okay for near term sales where you know the production costs, you know the volume involved and you have a fixed price sales contract in place. In these circumstances the currency agreement essentially allows you to fix everything and know your profit with reasonable certainty. The risk is minimal since hedging an already existing sales contract ensures you will have the USD cash available to deliver against the currency contract.
The problem arises, in my opinion, when these type of forward rate agreements are used over too long a time frame, when selling prices and volumes are uncertain, so there is not much certainty around you having the cash available to make delivery against the contract. Again in my opinion, these longer term exposures would be better off hedged using an option contract, which gives you the right, but doesn’t give you the obligation, to make the exchange.
Options cost an up-front premium for this flexibility (since they transfer risk), but this becomes a known cost and can be factored into your selling price just like insurance on other parts of the business. The up-front “cost” for forward rate agreements is based on the differential in interest rates between the two currencies of the contract. It is generally a small spread on the current market exchange rate (or “spot” rate), and depending on the interest rates, can even be a favourable rate compared to the spot rate.
I would reckon it’s the apparent costlessness of forward rate agreements versus options that produces the behaviours observed.
The unknown to me is whether the market for foreign exchange options is deep enough to get a fair price on the large values someone like a WMC would be interested in. You’d need a real expert to understand that.
Don’t ever hedge
It has to be remembered that foreign exchange (like all futures markets) is a zero sum game. For every winner there is an equal loser on the other side of the transaction, and visa versa. But this cossie equilibrium is not quite so simple. When you look at the big picture you have to take into account transaction costs, earned by foreign exchange dealers/banks, who are the only ones guaranteed to make money fromcurrency trading.
When you account for transaction costs then the companies with the hedge books will, overall, pay a price for the privilege of hedging.The answer? DON’T HEDGE EVER.
Sounds easy but it’s not.
Mainly because of pesky shareholders who insist on seeing a nice steady increase each year in company earnings and dividends. If they didn’t hedge (which in the long-run would deliver them greater shareholder profits) their year-on-year earnings graph would look like a dog’s breakfast, rather than
the gradual (but consistent) incline that fund managers and shareholders love to see.
And yes predicting exchange rates is easy with the benefit of hindsight. Would anyone in this country be willing to bet their life on where the $Awill be in 12 months?
Keep up the good work, Joel