Remember the KIKO contract furor? KIKO agreements (Knock-in Knock-out) agreements are a way to hedge against currency fluctuations. There were used extensively by Korean SME’s as the Won was rising. The were used perhaps too much, as many SME’s were left with big bills as the Korean Won went the other way, in a big way, last September. Facing bankruptcy due to these KIKO obligations, they sued.
Now as if this was not enough to make banks second guess issuing such contracts in the future, Korean courts exacerbated the problem. Saying in one instance KIKO’s were legal, and the other saying KIKO’s were illegal. You can consider the various merits of each case, but safe to say it created some ambiguity in the legal status of KIKO’s and offering them to potential clients who could benefit from them.
Yesterday, almost a year to the day the KIKO issue started to bubble, in the wake of a resurgent Won the Korean Finance Minister called an emergency meeting. At issue was the liquidity problems SME’s in encountering with rising raw material prices and falling revenues from a rising won.
Wow, if there was just some way SME’s could hedge against currency risks. Or more apropos, banks were willing to offer ways to hedge against currency risks. Yet for some reasons they just are not offering the chance to.
{ 35 comments… read them below or add one }
Yes, KIKO was a lesson for everyone. Korea’s large banks are all authorized to deal in currency futures now, so I’m sure simpler hedging products will be on the way soon, if they’re not already available. But because of the mess the banks made with their KIKOs, there’s a lot of contracts out there still to be resolved – if the courts nullify the contracts, the banks have to take paper losses (no cash losses, though). If the courts enforce the contracts, the banks are entitled to a big dollar payout, but if it’s too large, the client will just go bankrupt, or delay payment anyway, which would still be a loss. Too much blah blah: basically, the banks are going to lose on KIKO, and until those losses are realized, I wouldn’t look for a lot of other currency derivatives being made available to SMEs. End part I.
The crux of the case against the KIKOs has been that the banks sold them to people who didn’t understand them well enough to know what they were buying. I’m strongly inclined to agree. The contracts are SO one-sided that no reasonable person would buy it if they understood it. Let’s take a look:
Say you’re a mid-sized Korean exporter, and you get paid in dollars. The whole 3 years of 2005-2007 was a period of low volatility, but nonetheless, the won slowly strengthened from 1050/$ to 950/$ (so every dollar you got from your foreign customers was giving you less won – your expenses in Korea are in won, and your profit is in won. You’re losing profit to this exchange rate, and you can’t raise prices, because you’re competing with lower-cost Chinese competitors, etc).
A few times this exchange rate actually bumps down to 900, and that’s it, you’ve had it. But there’s a solution, the Korean banks will offer you a deal (my own example, I’ve never seen an actual KIKO contract):
Terms:
(a) if the Korean won stays between 900 and 980, the bank will agree to buy from you a certain number of US dollars* for a price of 970 won/$.
(b) if the Korean won strengthens above 900 (that is, 899/$ or less), the contract is voided. This is the Knock Out.
(c) if the Korean won weakens below 980 (that is, 981/$ or more), then you have to pay the bank DOUBLE or TRIPLE the certain number of US dollars*.
* The contract will be settled on a certain date, or a series of dates. You would probably choose the ‘certain number’ to be approximately what you expect to receive in payments from your overseas customers.
Why does signing this contract make you an idiot (and the banks shameless)? Answer in Part 3.
(c) above is, of course, the Knock In.
To see the problem, we just have to look at your upside and your downside risk.
On the upside, if your clients have paid you $10mil, and the won is now trading strong at 940, then you make 30 won/$ and book an extra 300mil KRW. Sweet. This is why you bought the contract, and things have worked out well. But if the won is 890 or stronger (your worst fear), the contract is voided and all you can do is trade your dollars for 890. You’re also out whatever the price of the contract was (basically an insurance premium). I also strongly suspect that the contract was written such that if the won EVER topped 900 at any point in time, then the contract was knocked out, even if the won then weakened back above 900 by the settlement date, but I don’t know this for certain.
Essentially, your upside, or the maximum amount of profit you could earn on the contract, was limited. Your downside risk, however, was unlimited.
On the settlement date, if the won was at 1100, you now owe the bank TWENTY MILLION DOLLARS (if you wrote a doubling contract). You can trade in your $10 mil for 11bil KRW, but the price of $20mil is 22bil KRW.
You have just lost 11bil KRW. What if the won weakened to 1300, 1400 or 1500? Since there is no theoretical upper limit to the extent the currency might depreciate, your theoretical potential losses are unlimited.
Final points: These contracts could be written for settlement in dollars or won. If you have to settle in dollars, then it’s YOUR responsibility to go out there and find another $10mil to hand over to your bank. You have to buy them on the open market, and if a lot of other KIKO holders are in the same position, then you’re all going to bid up the dollar.
This type of contract is a great hedge for the banks, because their downside risk is the opposite of yours – it’s limited by the 900 knockout. But their upside is unlimited by the knockin. And the Knock In only happens when the won in weak, that is, when dollars are scarce. That means the banks are freed from having to ensure their own dollar liquidity at a time when dollars are scarce – they’ve made it your problem.
Based on all this, I would say that it’s pretty much self-evident that the banks failed to adequately explain the risks of these contracts to the people who bought them. It’s probably a big reason why the new Capital Markets Integration Act (implemented in Feb) contains strict rules on how banks and other financial companies can conduct sales of investment products.
Last, it is a shame that some buyers who knew what they were buying will get off scott-free in this. Anyone who enters into a contract knowing what they’re doing deserves no help. But because the whole KIKO thing was such a cock-up, the courts are probably going to have to let almost everyone off the hook. But as I said, these will be paper losses, not cash losses.
I just thought of another fun way to look at it:
If the won was at 950 (20 won below settlement price), you made 200mil won on your $10mil.
If the won was at 990 (20 won above the settlement price), you lost 9,900mil on your $10mil.
You played a game where each point of potential loss was 50 times higher than each point of potential gain.
Great analysis by Linkd. Re: your point that there are many small business owners who didn’t really understand what they were buying, Bloomberg ran an excellent feature we reprinted here — http://joongangdaily.joins.com/article/view.asp?aid=2902791 — that looked at just such a Korean businessman.
Actually, I half-expected Linkd to bring up the topic of Jinsae Chosun, a shipbuilder which, despite its relatively smaller size, has dug a hole so deep that it simply stuns: approx. $1 billion (and fluctuating – worse, if the won’s value weakens relative to the dollar). This company builds ships which cost customers about $30 mill. on average, and had a two-year backlog. Yet, they set up exchange-rate derivative contracts for a greater value than the value of the contracts they held for new ships, and the exchange rate increased dramatically.
On the one side, you’ve got Kookmin, Shinhan and Hana, and on the other, you’ve got Merritz, Heungkuk Hwajae and LIG (with a host of other insurers along for the ride). Prior to a declaration of bancruptcy, these parties are trying to come to terms with which side has to take the hit. These days, from what’s in the papers, Heungkuk Hwajae appears to be the first to start bitching, but there are sure to be others.
A friend of mine had two rooms in his condo. His room and another room which was a bit smaller.
He says to me one day: “hey, why don’t you move in with me and I’ll rent you the other room for slightly less than half what I pay for the whole place.”
He adds: “you can lease your apartment to a tenant and you’ll gain a secondary source of passive income. Isn’t this idea great or what?”
In this scenario, my friend is a lot like the banks except in fairness to him, it was less attributable to greed than simply arithmetical stupidity despite being a public school teacher.
Mmmmmkay.
No one forced these businessmen to purchase FX options. Of course they cry now that they didn’t know what they were doing. Why weren’t they concerned that they didn’t know what they were doing when they were making money off these? Why is it OK for a bank to lose money, but not a company?
dogbertt, you are that portion of the wool around the sheep’s ass that the shearer doesn’t bother to shear, for it is smeared with too much shit to be worth the effort.
It’s a legal issue. I think I’ve presented the legal issue in sufficient detail for a lawyer such as yourself to look into it, if you’re curious as to what a judge may rule is ‘OK’. Your questions are so lay they’re low. Bother me no more.
Linkd for the
winself-goalSavored that over lunch.
To the uninitiated: I heap abuse upon dogbertt because he has a history of pettiness with me, not because his questions in comment 9 are “beneath me”. If anyone with honest intentions wants to discuss these arcane contracts further, please do so, and just ignore the spots of bother that skid mark in #9 keeps instigating. Thank you, and sorry for the interruption.
Seriously, one could make a case for legislation mandating some sort of “know your customer” rule regarding instruments such as KIKO’s – sort of like the requirements for private offerings under the securities laws – but such legislation does not exist and, in the absence thereof, Dogbertt is correct: there is no respectable basis for the courts to interfere with the enforcement of these contracts in accordance with their terms (as unfair as they might seem with the benefit of 20/20 hindsight)
Well, to be fair to the plaintiffs (I have no interest in the outcome of the litigation), there is no hard sell like a Korean hard sell. There is more than enough anecdotal evidence to suggest that it’s at least possible the banks leaned pretty hard on their SME customers inquiring about hedging products to compel purchase. There has been a demonstrated pattern of behavior — not inconceivable to anyone who knows Koreans — for the banks to cram ancillary products down the throats of their customers when time comes to roll over the short-term loans of those customers.
A deal’s a deal, and all that, but there is also a question of unconscionability to be considered in the context of alleged pressure by the banks. While I don’t think the contracts already made should be rendered void, I do approve of the FSS imposing certain conditions going forward on the banks’ sale of these products.
I’m quite inclined to agree with that. It’s hard to do business if people can’t trust that a legal contract will be enforced by the legal system. The fact that these contracts (which are so one-sided and so unbalanced in terms of their risk-reward ratios) were even signed fills me with wonder. I readily believe that some purchasers were so certain that the dollar would not rise that they were willing to ignore the 50:1 risk imbalance I exampled above, believing they were certain to get the 1 and never suffer the 50. But for many, probably most other purchasers, I have to assume they just didn’t get it, and that the sales process they experienced did not help them to get it. That is, they were duped, even though their signature appears on the bottom line.
Korea’s mutual fund industry has turned over hundreds of funds in the past few years also, many of them with assets under management of just a few tens of millions of dollars. People bought into these funds in a purchasing experience that was as simple as walking up to the counter to make a deposit and having the teller say “We’ve go a great BRIC fund that’s going up like a rocket. You’ll probably make 20% this year. Why don’t you put 10mil into it?”
No, it’s not fraud, but it’s not honest business either. The Capital Markets Integration Act therefore mandated a more strict fund-selling process that requires the risks to be spelled out, and requires some sort of appropriateness test for making sure that the investment product is right for the client (wishy-washy, I know. Don’t know the details). That’s just consumer protection, which is a an issue conservatives and liberals can debate the rightness of – but there it is. At some point when the gains/losses become too out of balance, governments will usually step in and make some rules (which will make new problems later on, of course).
With the KIKOs, they were ‘unfair’ in terms of the risk/reward imbalance for the buyer – the math was just SO far beyond what a reasonable hedging instrument would call normal. The court may find that is not simply a matter of “I make money I’m happy; I lose money I whine, complain and sue.”, because the two monies in that sentence are not at all comparable. But if the court upholds the contracts, that’s alright with me.
Then what happens, from an accounting point of view, is that those dollars the banks are owed get booked as revenue, and held in accounts receivable. Then they won’t collect, so eventually they write down the losses. Banks gain little or nothing, clients forced into bankruptcy, but the sanctity of the contracts is upheld. The alternative is government intervention (not wholly new to Korea or any other economy), clients are saved, banks record smaller write-downs, and new types contracts are created. The evolution of an emerging market.
Yeah, all that, but at the end of the day (not the “sanctity if contract but) the predictability of contract enforcement (ie., one of the sine qua non of efficient and fair markets) is more an important than that a few well deserving candidates get their ultimate darwin award.
I’d be cool with that. Some lessons have to be hard. The best environment is of course one in which all contracts are equally enforceable for all parties, without bias.
Amen.
Linkd> Great explination, however I wonder if the x2 or x3 KI is realistic, or simply illustrative. Just want to clarify that before somebody reaches a conclusion.
Carr> Yeah, when I had a business I was “strongly encouraged” to take out more money from Cho Hung than we needed, and then place the excess into some pension fund the bank was hawking. Sucked donkey balls.
There seem to be many similar examples around the world where financial institutions have to repay losses on investment products, etc. because they have not properly explained the risks involved to the purchasers. Without knowing the full details, this seems to be one of those cases and I would expect different judgements on a case by case basis depending upon the details of the particular sale. After hearing about general sales practices by banks, it sounds like a lot of the companies would have a good case.
As an example with a Korean angle, a few years ago Daehan Investment & Securities took JP Morgan Chase to court in the States over South American bonds (Argentina and Brady Bonds perhaps?) it had bought in one of its trusts as it argued that JP Morgan Chase hadn’t adequately explained the risk that they could lose everything and had believed that the principal was guaranteed. JPMC settled out of court for most of the losses I think.
The ‘double’ is pretty standard. I’ve heard of triples, too. Check the link in Sagwamun’s comment, plus this one:
http://joongangdaily.joins.com/article/view.asp?aid=2895337
I guess I should have said yesterday that “my own example” is based closely on real contracts that I’ve heard and read about, and not totally pulled out of my ass.
Linkd> Yeah read both those in research for my post. I still wonder if they are typical or atypical though.
et al> In my opinion this “we did not know!” defense screams of either a fallacious statment or simply a false statement.
For any who think that losses on these contracts are simply ‘paper’ losses, consider the Jinsae Chosun case: underwriters will possibly have to pay out, both on refund guarantees made to the shipbuilders’ customers against non-completion of their orders, as well as on policies taken out against the derivative contracts. Arguably, despite their being in the business of assessing risk (and profiting from that assessment), underwriters seem not to have had a full understanding of the mechanics of derivative contracts, nor of their potential to effect the completion of the orders they were insuring. One thing’s for sure, however: at least in this case, the financial loss will be real for someone.
I’m not an expert, but from what I know, the double is typical. I’ve never read of a triple before, but can imagine them getting sold. Dramatic, yes? But, after all, it was that which attracted so many customers into purchasing more than they needed in order to offset the short-term effects of exchange rate fluctuation on operations.
Such limited inside info as I have says the double is typical. Can’t give you any stats, though, cuz none exist that I know of.
Re paper losses: only for the banks (thought I made that clear, maybe not). If the court upholds the contract and the contract purchaser is forced to pay out, of course their losses are in cash and real. Also, the bank claims $10mil in cash earnings, and it’s real.
Other things you mention are written by third parties, generally called ‘completion bonds’, and those losses will be in cash and real, but they are not directly related to the KIKO (ie, the KIKO forced the shipbuilder into bankruptcy, triggering the non-completion, triggering the payment on the completion bond by the third party insurer – this doesn’t affect the bank that wrote the KIKO, or the shipbuilder. It’s between the people who ordered the ship and the third party financial firm that issued the completion bond).
But if the court invalidates the KIKO contract, then the bank never has to recognize the write-off, because the revenue was never earned, and the contract purchaser never has to recognize a loss. Also, any third party that issued a completion bond is secure, so long as the shipbuilder is still making ships. There might be some incidental accounting adjustments out of all of this, but no cash is involved.
Why it’s a “paper” loss if the contract is upheld: For the bank, it’s like this: the Knock In causes the contract purchaser to owe the bank $10mil. The bank records this as revenue earned. The purchaser defaults on the payment, and the revenue earned moves through the bank’s allowance for bad debts account, finally being written off as a bad debt expense. These mechanics lower the banks profitability, but no cash is involved – except to the extent that the purchaser’s default is part of its bankruptcy, the liquidation proceeds of which are spread among all the creditors; the bank will get a piece of this, but probably not nearly the full $10mil value.
- Something that might help this make sense is clarifying the idea of revenue. If I do the work I “recognize” the revenue, whether I’ve collected the money or not. If Carr spends two hours writing some legal opinion for a client, he bills them for, say, $600. That goes on the books as revenue WHEN THE WORK IS DONE. If the client doesn’t pay, it takes several months or more until the firm finally determines that it’s never going to get the money. At that time, you write off the $600, recording it as a business expense. On paper, you made $600 and spent $600, but no cash was involved. Same thing with that mythical $10mil that the KIKO was supposed to bring in. But if Carr sued the fucker and forced him to pay, or forced him into bankruptcy and sold off his assets to collect his money, then cash is involved. Whatever amount he collects BELOW the $600 is a “paper loss”.
Linkd:
Based on all this, I would say that it’s pretty much self-evident that the banks failed to adequately explain the risks of these contracts to the people who bought them. It’s probably a big reason why the new Capital Markets Integration Act (implemented in Feb) contains strict rules on how banks and other financial companies can conduct sales of investment products.
Do you know if this Capital Markets Integration Act is retroactive law?
I see absolutely no reason why the real economy (ie small/medium businesses that produces tangible goods) should be gutted for the sake of a virtual one based on speculative markets. Especially in these troubling economic times.
At some point in the natural course of human evolution, we shall abolish the use of financial instruments based upon random chance as well as scrap the interest-based monetary economy altogether, which puts men in bondage.
#4 Linkd:
Last, it is a shame that some buyers who knew what they were buying will get off scott-free in this. Anyone who enters into a contract knowing what they’re doing deserves no help. But because the whole KIKO thing was such a cock-up, the courts are probably going to have to let almost everyone off the hook. But as I said, these will be paper losses, not cash losses.
In Christian theology, this would be a real-life Earth bound example of Grace.
#16 Sperwer:
Yeah, all that, but at the end of the day (not the “sanctity if contract but) the predictability of contract enforcement (ie., one of the sine qua non of efficient and fair markets) is more an important than that a few well deserving candidates get their ultimate darwin award.
This is Legalism. A strict, literal adherence to rules and regulations, a position doctrinally opposite to Grace.
Legalism versus Grace.
…one of the sine qua non of efficient and fair markets
Another sine qua non of efficient and fair markets is that participants act in rational self-interest based upon transparent transactions with full information access. Whether rule of law has precedence over these other conditions seems to be the point of debate.
Thanks for the explanation, Linkd, but I was already familiar with that aspect of accounting. My point was rather about those third parties, who very likely stand to pay out. As you say, their losses will not the direct result of the KIKO agreement, yet they are significant, and they are real.
Moreover, the underwriters’ apparent lack of understanding of the shipbuilder’s financial agreements has arguably contributed to their being in the position in which they now find themselves. Frankly, had they fully understood the risk themselves, they would not have underwritten completion bonds to the magnitude that they did.
(Incidentally, completion bonds are referred to as ‘RG 채권’ in The Land of Morning Calm, with ‘RG’ standing for ‘refund guarantee’.)
A few remarks:
1. Accounting. Linkd writes: “The bank records this as revenue earned”. Au contraire — KIKOs are recognized on a bank’s books as a liability. Linkd misunderstands that a KIKO involves the sale and purchase of options and his example of a client stiffing Carr is inapposite. A full discussion is impossible here, but anyone interested in accounting for FX options can refer to IAS 39.
2. Greed. The common opinion seems to be that banks seek to profit from gullible customers. The truth is, banks do not speculate against their customers. They just don’t, for reasons that should be obvious. When a customer enters into a KIKO with a bank, the customer is taking a risk, based on that customer’s own view on future changes in FX rates. The bank, though, is not taking the opposite risk. Why? Because the bank will turn around and hedge its own exposure to its KIKO customer with another institution. Which is to say that the banks are not expecting a windfall from selling these products, because they have purposely limited their own upside and downside by counter-hedging. As far as “paper losses”, keep in mind that the banks will in many cases suffer actual monetary loss when a KIKO is terminated early, in the form of break and re-hedging costs. Of course, the customer doesn’t care about this and laymen don’t know it.
There is a fundamental misconception in the comments here that banks generate profits that are commensurate with the losses of their customers. Unh-unh.
3. Misselling. This is the crux of the complaints. Carr and Sperwer both hit on this. Let’s look at Carr’s examples. What Carr describes is called “tying” and is illegal in the U.S. It’s not allowed in Korea either, but it’s probably more fluid there than in the U.S. However, what Carr might not be taking into account is the cut-throat competition among Korean banks. Most Korean banks do not have the leverage to tie SMEs, who can easily pick up their chips and go to the next bank down the road. Instead, SMEs loved KIKOs because they initially made money on them and they kept placing their bets as many lost sight of the original hedging purpose of them and instead became speculators. Can I sue a casino because I won $5,000 over a week on the crap table and then lost it all in a single hand of blackjack?
The fact is that KIKOs offer a hedge that is attractive because of (a) its low price to the customer (often, nothing); and (b) the fact that it offers an enhanced return over vanilla FX hedges.
So do the banks simply foist off complex, hard-to-understand derivative products to customers, without properly explaining them? No. First off, banks are supremely sensitive to what is called reputational risk. Simply put, if any business gets a reputation for ripping off its customers, it will not stay in business long. So the banks have great incentive to, as Sperwer notes, have systems in regard to customer appropriateness. Banks do have matrices based on the type of product, the type of customer, and the sophistication of the customer that govern what and what they will not offer to their customers. If anyone has ever opened a retail brokerage account, you’ll have experienced a simpler version of this, where you will or will not be allowed to trade on margin, trade options, etc., based on your level of experience and financial sophistication. While this is not legislated by product, as Sperwer correctly notes (but note Geithner is rarin’ to “go there”), banks are required to comply with, and are audited and judged on, strict FSS customer appropriateness regulations (HT to Carr) that pre-date the KIKO kerfluffle. These are not merely window dressing, but taken extremely seriously.
Are the customers that unsophisticated? I’d hope that the CEOs and CFOs of shipbuilders and the like aren’t, but then again I can go back to the Orange County bankruptcy years ago, so … But then again, the KIKO “contracts” are written in Korean (and explained in Korean), the agreements that govern KIKO trading between banks and SMEs are written in Korean and approved by Korean regulators, and like any other contract, you have time to read it, ask questions, get comfortable, and then sign, or not. The KIKO “contracts” themselves have no hidden terms or features and even come with illustrative examples of risk and return. Not only that, each and every customer who signed one represented that he understood the product and its risks and rewards. And, KIKOs are legal financial products in Korea.
4. Lonestar. No doubt I will get a “hell yeah” from Sperwer when I note that there is more than a tad of “hometowning” going on here.
5. Upside/Downside. I am plumb mystified by the socialistic notion that the bank and the customer are expected to have equal levels of risk and reward. Sorry, but that is just not the way the system works in Korea, in the U.S., or anywhere. It may work when playing gin rummy with your parents in Medicine Hat, but it doesn’t when you’re playing with JPMorgan. Limited upside/unlimited downside is the norm for many financial products, even those offered to individuals. For example, I can today, if I want, call my broker and purchase a bank note with an equity underlying that will cap my upside at 19% with 100% downside participation. I wouldn’t expect the bank to cap my downside at 19% and again, if you think about it, it should be obvious why. A similar mechanism is at work here.
The CMIA was planned and drafted long before the current crisis and it really doesn’t have anything to do with commercial banks. Have you even read it?
No, but all the annual reports of the banks I’ve worked on (“proofread”, if you will) this year have said that their staff are undergoing training in new fund sales procedures so as to comply with the enhanced consumer protection measures in the Act, referring to the issues I raised above. Maybe those provisions were added on recently.
So, a KIKO contract terminates, the bank is owed money at termination, and the bank thereafter holds that on its balance sheet as a liability? Interesting. I’d check that again with your in-house CPA. For the bank to hedge its possible exposure for payouts if the contract terminates between the KI and KO points is logical. What’s to hedge with the windfall it receives if the contract terminates above the KI? “Damn, we have too many dollars!” Maybe a CDS on the client it’s driving into bankruptcy?
gbnhj- of course you knew that. Sorry for lecturing. To respond, let’s use this example: Shinhan Bank provides a refund guarantee to a Norwegian company that placed a $20mil deposit on a ship order. It is Shinhan’s responsibility to evaluate the risk that it might have to pay that money in case of non-delivery. Don’t you think Shinhan Bank ought to have the financial acumen to evaluate the KIKO exposure of Jinse properly? No sympathy for them.
Shinhan insured the possibility of having to pay out that guarantee with Meritz, a considerably smaller organization. Again, as a financial services company, Meritz should have the capability to evaluate the probability of paying out. No sympathy for them either.
So, I let my mind wander into the realm of pure daydreaming: Jinse entered the business as a newbuilder (maker of entire ships) only in 2007. Korea is very proud of being the world’s largest shipbuilder, and a little miffed that China will take over that spot in the near future. Orders abounded in 2007, so Jinse was able to set up shop, take orders, receive advance payments. Korea’s large banks with international operations provided services to support this growth (like the guarantee from Shinhan).
At some point, Jinse became a speculator, according to your comment. I don’t know what their turnover is, but since they bought KIKOs or other derivatives on amounts of dollars larger than their expected dollar receipts, then they were just speculating, becoming, in effect, a small hedge fund operating on the back of a shipbuilding business. We note also a news report saying that one of Jinse’s owners was Samsung Heavy Industries. With them standing behind Jinse, I suppose the banks had no problem issuing as many currency gambles as Jinse wanted to buy, along with the repayment guarantees, LCs and other financing.
With some exposure to real-world banking, Shinhan hedged its exposure by using Meritz as an insurer. Meritz wants to play with the big boys and just signed the paper without asking itself “Hey, this shipyard has never actually built anything. It has orders, which is nice, but the orders only amount to $300mil, it’s only going to make $30 mil profit on those orders, and it’s going to owe $1 bil on derivative contracts IF the dollar goes above 1000. Is it really safe to assume that these guys are actually going to be around to deliver those ships, knowing that the completion date for the ships is months or years after the KIKOs will come due?”
Ah, no problem – IT’S SAMSUNG!!”
(I should add that Samsung Heavy only has its 2007 IR online, and there’s no mention of Jinse in it. So I’m just rumor-mongering here without knowing what it’s stake in Jinse is. Could be 1%, could be 90%).
So, a lot of things are involved besides the KIKOs. Did Jinse go bust because of the KIKOs, or did it go bust because of a global economic crisis that caused a lot of other companies to go bust? Or was Jinse just a badly managed company that never got off the ground, and when its insiders realized this, they took the opportunity to use Jinse as a speculative vehicle, knowing they could just let Jinse go bankrupt without transferring its liabilities to themselves if their bets failed? Swirl in some potential government involvement with promoting shipbuilding as a component of national pride, and that little sleight-of-hand that Jinse played by delivering one customer’s ship to a different customer based on a “verbal agreement”, and you have a royal mess.
The global economic crisis affected exchange rates, but that’s immaterial – exchange rates are not static, hence the desire for KIKOs. That the bank’s customer suffered under the weight of loss does not change the fact that it benefited by the surge of profit, which were both due to KIKOs. Or, did you mean to suggest the cancelling of orders? Well, as mentioned, they had a two-year backlog when the shit hit the fan with their KIKOs.
With respect to the Jinse, they were doing fantastic business: $32 mill./hull on average, with 8 month turnarounds on orders. (BTW, thanks for providing the English spelling of their name; I’d only seen it in Korean previously). You mention that they entered the market as a newbuilder only in 2007; that’s true, but they’d been operating in the market for years as a provider of major systems to other shipbuilders. There was nothing green about this company in terms of building – that’s why they had so many orders. They were not as unknown to the market as your example seems to indicate, and they certainly had no initial trouble delivering hulls on time, and on budget. It’s correct to say that the market’s interest in them was in part influenced by the general reputation of Korean shipbuilders, but it’s more accurate to say that customers already knew who they were and what they could do, because they’d been buying from them, in effect, for years.
And, as shipbuilders in their own right, Jinse’s growing need to hedge won losses in a dollar-denominated market is understandable, but their purchase of KIKOs in excess of their need goes to fiscal mismanagement. Sorry, but they were very familiar with the financial product, amd enjoyed the money they made from it. Samsung is a red herring here – if you’re looking at news articles, note that Samsung is not mentioned as being involved with this debacle. Jinse’s management is on the hook for this, and always has been.
In my view, the underwriters appear to have lacked a full understanding of the risk, but as it’s part of their business so assess risk, they may be faulted for not doing their jobs as well as they ought to have. And Jinse’s management, with its desire to sign KIKOs for an amount greater than its orders, is entering into activity that can only be described as speculative.
I wouldn’t expect Samsung’s name to appear in the news stories, of course. I would only expect their name to come up in the risk assessment meetings. Anway, yeah, things suck. If they had a good shipbuilding business and a bad hedge fund, well, that’s what AIG was – a good insurance company with a bad hedge fund strapped onto it, and its risks were overlooked by everyone, too.
If Jinse was allowed to overhedge (and its counterparties in turn allowed to overhedge those hedges), then it’s sort of like everyone assumed that the continuing organic growth in shipbuilding generally would be enough to cover everyone’s ass, sort of like the assumed continuing organic growth in residential property prices was supposed to cover the asses of the whole Western world’s financial industry.
A lot of observers think we’ve only just begun what could be a long period of financial companies suing other financial companies (globally, not just Korea) – but that’s just one of several shoes that are still to drop.
Korean banks are in trouble. Hiding it will not work.
3000 won per dollar by the end of this year.
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