Derivatives Strategy The Legacy of BT
The Legacy of BT
Five years after the P&G scandal, Bankers Trust no longer exists and the debacle continues to inspire rancor and debate throughout the industry. But everybody agrees on one thing: the derivatives market has never been the same.

By Nina Mehta

Five years ago, we published an incendiary article about a series of Bankers Trust derivatives deals with Procter & Gamble, deals that ran into the hundreds of millions of dollars, went wildly sour, and wound up on the evening news. Based on the transcripts of tapes Bankers Trust turned over to the authorities in 1995, the article traced how those swaps turned into such a rude mess for the Pampers giant and an unexpected legal disaster for the bank that, by many measures, invented derivatives.

When we told some of the people involved we were reprinting that original article in this issue, they were as angry as they were a half-decade ago. People accused us of mucking around in ancient history, excavating old wounds, and sensationalism.

They are right. The story republished on Page 26 is sensational, what happened to BT was sensational, and—five years out—BT vs. P&G is still an incendiary topic. But for all the wounds that gradually closed and the changes wrought in the derivatives market, the BT debacle still generates a Rashomon-like rash of differing opinions about what really happened. And about the significance of l'affaire P&G.

BT, say former BT employees, was the catcher of falling knives. P&G, say others, was a Cincinnati-based lamb, duped by shysters, somewhat naive, and, perhaps, somewhat slow to unwind losing positions.

A former BT man who continues to work in the industry initially refused to talk about the P&G calamity, but then went on a vitriolic binge for 20 minutes, rehashing ancient history. The conversations on the tapes were taken out of context, he argued, it was locker-room talk, and the Pampers-purveyor had slyly retooled itself in a genius PR assault as a "hometown, homely, feel-good company against big bad Wall Street.” The swap deals that blew up would never have affected the sale of Pampers, he said bitterly, "but BT, built on trust, had everything to lose.” And did. The tapes changed the course of BT history, he said. And the history of derivatives.

Others at BT weighed whether to talk to us, and either declined or took the it-was-out-of-context view. Other banks were also aggressive back then, we were told; the high-octane, low-wattage media was partly at fault; we should not be blithely dragging that old article back out of the shadows; and so on. Another former BT official agreed that the P&G affair was a watershed event in the bank's history. But he went on to add, "I think it's fair to say that this was not per se, in the view of many people, a scandal. It was a commercial dispute between two very aggressive institutions.”

Of course, it was a scandal. "BT was trying to sell people products they didn't need in a very pushy, aggressive way that did hurt the industry,” snaps an old hand at derivatives who used to work at Bankers Trust. "BT made an industry of taking advantage of people. That turned out to be scandalous.” Others interviewed for this article offered similar assessments.

"No one is doing anything today in the field of derivatives that BT wasn't doing five years ago.”
—Mel Yellin


The BT vs. P&G fiasco was a lesson waiting to be learned, say many. So what was ultimately learned? On the buy-side, that end-users shouldn't buy products they don't need or understand, and shouldn't fake sophistication by recklessly signing onto derivatives transactions.

On the sell-side, what some took away from the fiasco was the simple fact that people don't like to lose money. And when they lose, they may well shift the blame. Put nicely, the P&G lawsuit (and subsequent filing of racketeering charges against BT) complicated the industry's understanding of credit risk. Stan Jonas, head of derivatives products at Fimat USA, says that P&G looked like it had a lot of silly people on staff but actually had very smart people, "because they understood that when they lost they would never have to pay. Heads they won, tails they also won. Rather than paying up, they read their contracts and went to see their lawyers.” Denis Forster, a lawyer who advised P&G and its trial counsel during the BT affair and who now counsels Microsoft and other large companies, argues that P&G had been wronged, but that he's now often approached by people claiming without justification to have been defrauded by dealers. "While some have been truly harmed, there are people who bet on red, it comes up black, and then they want to sue,” he says.

Bye-bye BT

But what exactly is the legacy of BT vs. P&G? For starters, naturally, the entrepreneurial investment bank is off the map. Some ex-BT bankers claim that the chain of events triggered by the P&G debacle led to the takeover by Deutsche Bank last year. The scandal was large enough to rock the leadership of Gene Shanks, who had built the bank into a derivatives behemoth. With the Federal Reserve Bank of New York breathing down BT's neck after the lawsuit, the bank was pushed to make a conservative CEO appointment—in this case, Frank Newman, a former regulator.

In the end, though, safe was as safe did. Newman took BT into investment banking, minimized derivatives and committed the bank to emerging-market debt. That eventually led to the Russian losses in the summer of 1998, hairy third-quarter losses and the takeover. "I think there's a direct correlation between all these events,” acknowledges Duncan Hennes, the BT treasurer during the takeover. "If you follow the dots, it all falls together.”

Mel Yellin, BT's general counsel at the time of the merger, denies a direct correlation between l'affaire P&G and the bank's ultimate absorption into the German bank. He believes that BT's legacy of innovation is the thing that counts. "No one is doing anything today in the field of derivatives that BT wasn't doing five years ago,” he says.

In spirit at least, this is true. Whatever people think of the entrepreneurship at BT, and its well-chronicled cowboy attitude toward clients, BT was an innovator. "Pioneers always get arrows in their back,” says Jonas. "That's how you identify the pioneers.” Being a Lone Ranger has its drawbacks, yet for the industry all was not lost. The wound BT suffered at the hands of P&G's legal machine and public opinion affected the business of derivatives in ways that are large, broad and fundamental. And basically positive.

Once burned, twice shy

The most dramatic consequence of the BT disaster was the apotheosis of risk management. Oversight improved, best practices were developed and the industry matured. "The industry is a lot more careful about what they sell and the level of comfort they get to with their counterparties now,” notes a senior equity derivatives dealer. "Institutions engage in more thoughtful and analytical discussions with end-users about the risks, ramifications and behavior of instruments under different scenarios,” admits the former BT official who saw a "commercial dispute” where others cried "scandal.”

Whether this is a result of dealers' legal worries or the singeing of corporates in derivatives deals doesn't matter much. The fact is that treasury departments now have stronger oversight and risk management processes in place.

There is also a school of thought that BT ultimately bestowed confidence on the industry. In the wake of the P&G dustup, people took a hard look at what they were doing. Virtually all end-users now have a better idea of the trades they're entering into, points out Rick Grove, CEO of the International Swaps and Derivatives Association. That's good for them and it's good for dealers, since the dealers are in for the long haul. "The profit on one deal pales in comparison to the money they make over the course of years in dealing fairly with clients,” he asserts. "That's the silver lining in the cloud that hung over the industry because of P&G.”

Grove even traces the growth in volume of derivatives transactions back—at least in part—to the P&G affair, since that was the fount of better risk management practices. And the increase in transactions resulted in other benefits, such as collateralization and marking to market, as the industry's expansion outpaced dealers' willingness to take on credit risk.

Corporate treasury departments in particular took clear measures to spiff up their risk management policies after the P&G lawsuit. In the early 1990s, many corporate treasurers were not hedging exposures, but were basically trading. Large corporates had the relevant product knowledge, but risk management procedures were often lax. "More policies were put in place and real expressions of risk appetite issued by corporations to their treasury departments,” notes Michael Haubenstock, a partner in the financial risk management practice at PricewaterhouseCoopers.

"Investment banks still sell junk to their customers. but they do it in a more conservative way now and in a more structured manner.”


The BT fiasco also gave the fledgling discipline of operational risk a shot in the arm. A tail event, it "drew attention to the legal and reputation consequences of bad deals, and raised the issue of suitability risk,” adds Haubenstock. Dealers had to think about and monitor what types of instruments were being sold to which customers, what was disclosed about valuations, whether those valuations were fair, and whether clients understood exactly what was sitting in their grocery basket.

Not everyone sees these changes in the industry as uniformly beneficial, however. The emphasis on clinical risk measures and risk parameters can make people naive. "Let me put it this way,” says Fimat's Jonas. "The derivatives market as we know it would not have been created if BT had a VAR system 10–12 years ago when they started this business. Everybody would have been fired.” Others are also skeptical of too strong a faith in numbers at the expense of innovation and real understanding.

For all the changes wrought in risk management, one thing that has not changed since the heyday of Bankers Trust is the mandate of traders. "Investment banks still sell junk to their customers,” says the former BT derivatives pro. "That's their business. But they do it in a more conservative way now and in a more structured manner.” Another point often glossed in discussions of risk management is that "products are sold, not presented,” adds Joel Miller, risk manager at Maxcor Financial, the parent of interdealer-broker Euro Brokers Inc. "The trader's job is to make money, and the client's interest almost always interferes with this objective.”

Although there is more disclosure in the markets now, options remains an area where there's still insufficient disclosure about the pricing of risk. Optionality is the built-in nitroglycerin in swaps gone awry, argues Forster, the former P&G attorney. And it's frequently coupled with leverage, which heightens the unknowns. A recent example of this is the spate of putable/callable reset bonds sold by the Street in 1998 and 1999. "A narrow profile of risk was included in the presentation,” notes Miller. "But when all the real costs were tallied, the transaction often had a significant negative present value from the issuer's perspective.” (For more on the unsavory side effects of these structured bonds, see www.kalotay.com/putcall.pdf.)

One early consequence of the P&G lawsuit may also come back to bite corporates. After the case was settled (in P&G's favor), dealers began writing provisions into their ISDA master agreements with clients to blunt the effect of what's now known as the "superior-knowledge argument,” which imposes a disclosure obligation on dealers; the provisions generally state that corporates are responsible for understanding their deals and are not relying on what the dealer tells them. Smaller corporates and those not represented by counsel now sign away protection they may need in the future, says Forster. Other industry lawyers, however, shrug this off as an ineffective legal ploy by the investment community, and therefore misplaced effort.

Much has clearly changed since the Bankers Trust tapes were released five years ago. Most significantly, the industry was forced to grow up. Yet despite the legacy of BT vs. P&G, two bare-knuckles facts simply can't be wished away: complicated instruments are complicated and entail risks; and however scrupulous the risk management, fat-tail events will always be fatter after the fact.

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