ANALYSIS - As derivative deals go bad, banks in firing line

SINGAPORE/HONG KONG (Reuters) - Investment banks already under fire for risky lending practices in Western markets face another barrage of criticism over selling a raft of currency and commodity derivatives that have now turned toxic.

Companies from Chinese power generators to Mexican tortilla makers, some already reeling from the global financial crisis, are being hit a second time by these trades, including complex products that seemed to offer easy money or zero-cost hedges.

Now that many of those deals are coming back to bite them, some companies are lashing out at their bankers. Such attacks may be unfair, but the reputational damage to an industry already a scapegoat for global woes may not be easy to undo.

At the core of the issue is the companies' intent: Were these firms lured into instruments they thought would effectively protect them against downside risks? Or did company executives take a punt on the market by exploiting the grey area between a hedge and a speculative bet, circumventing risk controls?

Caveat emptor -- buyer beware -- goes only so far, and some experts say this may only be the beginning of a parade of a accusations, and potential lawsuits, as volatile forex markets and a sharp dive in commodities roil corporate trades.

Still, investment bankers point out that many buyers were perfectly aware of what they were getting into.

"If people were not properly informed of the risks they were taking by a person selling the product, then I think the seller should be responsible," said Beijing-based Philip Partnow, a managing director at UBS.

"If people were properly informed then the buyer made a decision made on appropriate information and the buyer has to be responsible."

BIG HITS

When done right, the complex derivatives now coming into the spotlight can be a proper hedge against exposure to a certain market or currency. When done wrong, they're speculative bets that can go terribly and quickly bad when the markets move against them.

In South Korea, nearly 100 smaller firms filed a class action lawsuit this week against over a dozen banks -- including Citi, Standard Chartered's local unit and HSBC, as well as a number of local banks -- seeking to nullify currency deals that threaten to sink them.

The "knock-in, knock-out" currency trades they bought allowed them to sell dollars at a fixed rate as long as the won remained in a set range. But in late September, the won fell as much as 30 percent, forcing them to sell dollars below the market rate.

In a more extreme case, Hong Kong-listed CITIC Pacific racked up losses of up to $1.9 billion tied to a forex derivative called an "accumulator", which in simple form allowed the buyer to collect a premium if currency rates remained steady -- "money for nothing", according to brokerage CLSA.

But the Australian dollar dove sharply, exposing CITIC to deepening losses. The company blamed executives and its internal controls, not its bank, but bankers may find it increasingly difficult to sell accumulator products in the near term.

In Mexico, where companies including tortilla maker Gruma are reeling from forex hedging losses as the peso sinks, the central bank has said irresponsible bankers are partly to blame for selling unsuitable instruments.

"The investment banks, which accepted as a counterpart a company that has nothing to do with the kind of products they were dealing, well, it seems to me there was a lack of professionalism, to put it lightly," Mexican Central Bank Governor Guilllermo Ortiz said in a radio interview last month.

TOUGH TIME AHEAD

Investment banks have already been pilloried for crafting bundles of securities that helped set off the worst financial crisis since the Great Depression, including repackaged sub-prime mortgages and credit default swaps.

And even without a legal basis, the bankers who market these derivatives fear they're in for a tough time collecting on loss-making contracts and selling new ones, given past practice in Asia when many companies simply refused to pay up.

To be sure, many companies manage their cost risks through derivative deals they understand fully, often opting to pay a small premium for protection against downside risks.

But bankers say that many firms in Asia and Latin America -- less experienced than their Western peers and more averse to paying a fee -- are attracted to higher-risk derivatives that are sold at zero cost or even generate some income.

These can be effective hedging tools if markets remain stable. But as recent history has shown, they also can expose firms to nearly unlimited losses if markets move unexpectedly.

"The reality is that there is a market for speculative derivatives, especially in Asia where executives are keen on saving even a fraction of a basis point," said one Hong Kong investment banker.

Energy consumers may be next in line, say some bankers.

Oil prices have tumbled from a record high above $147 a barrel in July to a year-and-a-half low under $60 on Friday. Prices fell 33 percent in October, the biggest monthly loss ever.

"It's obvious more of these things are going to come because a lot of consumers have done some exotic hedges with a downside at $100 a barrel," said one senior marketer at an investment bank in Singapore, the main hub for energy trading in Asia.

Morgan Stanley and Goldman Sachs remain by far the largest of the energy derivatives sellers in a market they have dominated for two decades. Yet up-and-comers from Barclays Capital to Citi to J.P. Morgan have worked furiously to take market share, with some success.

LITTLE BASIS

While shifting the blame to bankers may be a popular strategy, it's unlikely to be a winning one.

In one of the last high-profile derivatives disasters in Asia, China Aviation Oil ran up a $550 million loss after doubling down on oil option deals in 2004, and the following year sued Goldman's commodities trading division J Aron, alledging it failed to explain the risks CAO was undertaking.

The case was withdrawn before it went to trial, but as a result many banks now require customers to sign documents confirming they understand the potential downside of their deals.

(Additional reporting by Noel Randewich in Mexico City)