UPDATE 1-Beijing’s derivative default

by Shu on October 7, 2009

in Finance

* State-owned firms may default on commodity hedges – report
* Bankers dismayed, confused by report; seek more details
* Lawyers question legality of the move
* Traders suspect lurking losses may have prompted warning (Adds analysts

By Eadie Chen and Chen Aizhu

BEIJING, Aug 31 (Reuters) – A report that Chinese state-owned companies
will be allowed to walk away from loss-making commodity derivative trades
provoked anger and dismay among investment bankers on Monday as they
feared it may set a damaging precedent.

The State-owned Assets Supervision and Administration Commission, the
regulator and nominal shareholder for state-owned enterprises (SOEs), told
six foreign banks that SOEs reserved the right to default on contracts, Caijing
magazine quoted an unnamed industry source as saying in an article
published on Saturday.

While the details of the report could not be confirmed, it was Monday’s hot
topic in financial circles from Shanghai to Singapore as commodity marketers
feared that companies holding underwater price hedges could simply renege
on the deals, costing banks millions of dollars in profit.

The warning from SASAC follows a series of measures from Beijing this year
to crack down on the sale of derivative products by foreign banks to Chinese
enterprises, principally big consumers, who bought protection against higher
prices last year only to watch the market collapse — leaving them with losses.
While many companies including top airlines have come clean on the losses,
some analysts fear another wave may follow.

"I wouldn’t be surprised if more state firms emerge with big derivatives trading
losses, otherwise SASAC wouldn’t come out with such a radical move," said
a Hong Kong-based derivatives analyst, who like most other industry officials
and bankers declined to be named due to the high sensitivity of the issue.

A SASAC media official said on Monday that he was waiting for the "relevant
department’s" official comment before he can clarify to media. A government
official said that the Bureau of Financial Supervision and Evaluation under
SASAC was handling the issue. The official declined to be named and did not

Spokespersons at Goldman Sachs (GS.N: Quote, Profile, Research, Stock
Buzz) and UBS (UBSN.VX: Quote, Profile, Research, Stock Buzz) declined
comment, and media officials at Morgan Stanley (MS.N: Quote, Profile,
Research, Stock Buzz) and JPMorgan (JPM.N: Quote, Profile, Research,
Stock Buzz) were not immediately available for comment. All are major global
providers of commodity risk management.

No bank were named in the Caijing report. The SASAC media officer alsodeclined to identify any specific banks.

"It’s a handful of companies who are being encouraged by regulators to renegotiate,"
said a second banking source. "It’s outrageous, but it’s China, so everyone is treading very carefully."


For banks that are hoping to sell more derivatives hedges in China, the
world’s fastest-expanding major economy and top commodities consumer,
the danger goes beyond the immediate risk to existing contracts to the
longer-term precedent that suggests Chinese companies can simply renege
on deals when they like.

The report follows an order from SASAC in July that required all central
government-controlled state companies engaged in trading derivatives to
make quarterly reports about their investments, including details of holdings
and performance.

But the reported letter opened several important questions that could not
immediately be answered.

"If we were among the banks receiving that letter, we would be very angry.
But now the key is to find out more details on the letter: In whose name the
letter was issued, the government or the corporate’s? And under what was
the reason for defaulting?" said a Singapore-based marketing executive with
a foreign bank.

The source, whose bank did not receive a letter, said that Air China, China
Eastern and shipping giant COSCO — among the Chinese companies that
have reported huge derivatives losses since last year — had issued almost
identical notices to banks.

"If it’s in the name of the government, the impact will be very negative," said
the source, who declined to be named.

Beijing-based derivatives lawyers said the so-called "legal letter" has no legal
standing — SASAC as a shareholder has no business relationship with
international banks.

"It’s like the father suddenly told the creditors of his debt-ridden son that his
son won’t pay any of his debt," said a lawyer from the derivatives risks
committee of the Beijing Lawyers Association.

It’s also unclear why Chinese state firms, which have complained that their
foreign banks sometimes did not disclose full information of potential risks
when selling them complicated products, did not seek redress through the

"If that is the case, these firms should seek through legal measures to
safeguard their rights, instead of turning to the authorities for political
interference," said a different lawyer.

SASAC took over the job of overseeing SOEs’ derivatives trading from the
securities regulator in February after several Chinese firms reported huge
losses from derivatives.

For a factbox of China’s derivatives debacles:[ID:nPEK206094] (Reporting by
Eadie Chen and Chen Aizhu in Beijing, Alfred Cang in Shanghai, George
Chen and Michael Flaherty in Hong Kong; Editing by Jonathan Leff)



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