[Viewpoint] Banks are once burned, never shy

South Korean companies got their first bitter taste of the exotic financial instruments called derivatives during the Asian currency crisis in 1997-1998. That happened when a total return swap, a derivative contract tied to currencies in emerging Asian markets packaged by JPMorgan, flopped disastrously because of the start of the Asian financial crisis.

Local investment banks that bought the instrument designed to reap gains on the rise of the value of the Thai baht and Indonesian rupiah lost heavily when the currencies tumbled and ultimately crashed. SK Securities had to cough up five times more than what it paid for the financial product. SK Group trembled due to a liquidity crunch at its securities arm.

Smaller securities companies without a parent group to bail them out were sold off or merged into banks. At the time, investment banks kept mum on the losses because any rumor of their exposure to total return swaps would spur bank runs.

Credit derivatives, now a household word for hedging financial instrument, were basically incomprehensible to local players at the time. Investment banks could not understand why they lost so big. One SK Securities executive suspected JPMorgan had sold the product betting on a financial crisis in the Southeast Asian market.

Korean companies became easy insurance targets on those catastrophe assets. “[Foreign] buyers probably reaped huge gains from the risk protection due to the plunge in baht value,” the executive grumbled. But the ambiguous and essentially masked nature of the instruments made it difficult to prove a rip-off. Korean companies failed to make a case against JPMorgan and only presented themselves as “losers.”

Despite the fiasco, Korean investors failed to learn. The next lesson involved a more sophisticated high-risk, high-return tool called “barrier options” with knock-in and knock-out options, which can only make money when the underlying asset reaches a certain price. Local companies, blinded by the high return promised by a Wall Street-based bank’s local branch, bought up such options from 2005 and lost heavily when the won sank. Cumulative losses reached 2 trillion won ($1.8 billion) and some companies went belly up.

Companies filed a suit against the foreign bank. They accused the bank of insufficiently explaining the risks and making huge money for foreign investors at their expense. The bank defended the legitimacy of the investment tool, saying it cannot precisely forecast potential losses for its clients. It even put a Nobel Prize laureate in economics on the witness stand to explain how the tool works.

Korean companies nevertheless continued paying a high price for their continuing education in derivatives. The next lesson was in debt securitization. The local financial industry got caught in the global financial meltdown when collateralized debt instruments soured and caused various problems in 2008. Woori Bank by 2007 incurred 1.6 trillion won from investing in collateralized debt and credit debt swaps.

The finger-pointing went on all over again. Woori claimed it was unaware of the risks of the products while critics chastised the bank’s incompetence and ignorance. The bank and clients fought bitterly, but no one thought of blaming the American investment bank who sold and profited on the product.

The U.S. Securities and Exchange Commission brought an unprecedented civil suit against the world’s biggest investment bank, Goldman Sachs, on fraud charge. It accused the bank of failing to disclose the risks and key information tied to subprime mortgages, causing investors $1 billion of losses when the housing market slumped.

Goldman Sachs vehemently denies the charges and plans to defend itself and its reputation. But it may not breeze its way out easily: President Barack Obama is expected to make Goldman a scapegoat in pushing for a financial reform bill.

Evidence of Goldman Sachs’ deceitful business strategy is ample. In 2006, it held a garage sale on collateralized debt obligations bundled up with subprime debt at a time when hunger for this complex and dubious investment was at its peak. Soon afterward, the housing bubble burst, also wiping out the home mortgages the securities were based on. Investors lost while the seller pocketed the fees.

The company is also suspected of precipitating the Greek default crisis by selling a hedge fund to insure against the country’s default on sovereign debt. The New York Times reported that Goldman Sachs and other Wall Street banking giants have been betting on the Greek default.

If Goldman Sachs is proven guilty, it will likely send a grave message to the industry worldwide. Local investment banks may have to think twice before making blind investment bets on larger foreign counterparts’ recommendations, as dodging responsibility will no longer be easy.

*The writer is business news editor at the JoongAng Sunday.
Translation by the JoongAng Daily staff.

By Yi Jung-jae