Black swan event? China cancelling derivative contracts

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 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 elaborate.

Spokespersons at Goldman Sachs and UBS declined comment, and media officials at Morgan Stanley and JPMorgan 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 also declined 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.
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All of these securities were sold as "investment grade" when, in fact, they were really weren't. The ratings firms were part of the problem by going along with this Ponzi scheme. Seems like we figured there were lots of people to skin out of their savings in China, but their government has other ideas. This won't help our financial mess...

The article is speaking about price hedges - and unless I'm mistaken, they're talking basically Futures or Put or Call contracts on commodities.

The piece mentions 3 companies, Air China, China Eastern, and shipping giant COSCO. That's 2 airlines and a container ship operator. What do those three have in common? They buy large amounts of petroleum products. Jet fuel and bunker fuel (Basically diesel). If they tried to buy large quantities for future use and the price of the commodities fell before they took delivery, they stand to lose money. Depending on which side of the trade they wanted to hedge (price rising or falling) they could buy or sell Puts or Calls. Buying a Put gives them the right but not the obligation to sell at a specific price for a specific period of time. Buying Calls gives them the right but not the obligation to buy at a specific price for a specific period of time.

Selling those same options obligates them to either buy, in the case of a sold Put, or sell in the case of a sold call. If the contracts trade away from them, they can be very costly.

That is apparently what certain Chinese state owned companies want to do; walk away from the obligation to make good on their options and/or futures contracts.

Futures, Puts and Calls are likely the derivatives mentioned and they are NOT given a rating of any kind vis-a-vis their "investment grade" and they are in no way a "Ponzi scheme". They are traded worldwide and are a commonly accepted method of hedging or protecting a buyer of large quantities of a given commodity from a violent price swing.

A few definitions;
Basic explanation of a Hedge
Delta Hedging
Straddle
The Options Guide.com

They can be incredibly complex and difficult to understand (I get lost in the minutiae, no doubt) and that fact is mentioned in the article as well, but no one held a gun to the head of any of those companies purchasing managers to enter into these contracts. Walking away from a freely entered into contract or an obligation on the open market sets a very bad precedent.

I really didn't read further into the article...I thought this was tied to the CDO's that are creating such financial problems in the world economies. If they're not meeting obligations on puts on forward commodity trends, that's bogus.

They, unlike the people in our government, aren't fooled nor pleased by the pump and dump tactics of financial wizards, and they are rightly protecting their people, as a government should, from those banks' gotcha games.

that an entity freely entering into a hedging contract is a victim of "gotcha games"?

This subject matter is not about Ma and Pa Chen or the average wage earning Chinese citizen. It's talking about companies the size of Delta and United Airlines and Union Pacific Railroad and THEIR corporate decisions.

I've read your posts and I get that you are passionate and convinced you are correct. You seem to be well read and have a grasp of many of these complex financial issues. But from my reading of the article in question, this has NOTHING to do with any "pump and dump tactics of financial wizards". It seems to be more of a situation where certain Chinese individuals and entities entered into agreements they perceived to be of specific benefit to them at the start should they pan out but when the market turned away from them and they stood to lose money, they decided to renege on those agreements.

Individuals and companies enter into commodity hedging contracts around the world every day. If Norwegian Cruise Line or British Airways or Consolidated Edison decided they weren't going to meet their obligation if a fuel contract they hedged went against them, what do you think would happen? Should they be excused? Should they be allowed to say "fuck you" and walk away? If they did, would you do business with them in the future? Should anyone?

This isn't about the Chinese "protecting their people". This article talks about STATE OWNED OR SPONSORED COMPANIES throwing their Teddy out of the pram (as the English are known for saying) because they made a bad financial decision.

Many of your posts have the theme of insisting financial entities own up to their fuckups.

Why do the Chinese in this instance get a pass from you?

Edited to add one more thing;

This story doesn't involve Wall Street or the Big American Banks, either. It is about contracts for commodities most likely entered into with brokerages or exchanges in Hong Kong and/or Singapore. The Chinese need to take this one on the chin and move the fuck on. Edited again to place the strike through the previous statement. I have no way of knowing if its accurate and therefore wrong to say so. My apologies.

And a lot of the worst bullshit leads right back to the same people, time and time again.

http://www.businessworld.ie/livenews.htm?a=2470412

Morgan Stanley, Goldman Sachs, UBS, JP Morgan... derivatives contracts. Sound familiar? It should, those are the same products that blew up AIG.

These banks are playing an "I win, you lose" game. They take extremely risky and ill-advised bets that have great payoffs in the short term, and cash in on that to the tune of billions in "bonuses". However, when those very same bets go bad, they have their bought-and-paid-for legislators - the people who are supposed to be representing us, take our money, without our consent, to cover their losses.

This isn't banking. It's financial fraud, organized and perfected into a science. That's what those educated menaces with the MBAs have been trained to do, in places like Columbia U. and Harvard. They are a pox on humanity; a parasite without even the good sense to know not to kill the host. Their greed is obscene and unrelenting, and their appetites grow with each new morsel of our flesh and blood that they consume.

So why do I give China a pass (on this)? Because I'm relieved to see somebody, anybody, who is not willing to take this shit from Goldman and the Morgan brothers and all of their kind. And I think their mercantilist trade policy protects their people from the depredations of allegiance-less, transnational corporations which have proven time and time again that they are willing to destroy the long-term well-being of everyone, even themselves(!), for short-term profits; and that we should be emulating this trade policy, because the people of this country also need the protection of their government from those very same predators.

I am fully willing to look like a crazy person so people can go look shit up and try to prove me wrong. I bet a lot of people here have done just that, and in the process of doing so they themselves discover what I have discovered - that there is not even the remotest semblance of fairness in the way today's economy is run, that the American Dream is dead, by murder-1. That there is no way the Goldman Sachs types will ever play fair, that they must be physically restrained from running rampant and stealing the wealth that actual productive, hardworking people in this country generate through blood, sweat and tears.

I voraciously consume information on this topic because what is happening so offends my sense of justice that I cannot in good conscience look away, or be satisfied with platitudes like "that's just the way it is". I highly encourage each and every person here to spend what time they can learning the truth of what has been going on - then everyone here will be just as angry as I am about all this.


EDIT: To summarize my thesis: The banking elites have used their power to turn our economy into a mechanism that supplies them with the entire surplus of the country, through the instruments of debt and interest payments. If we value our quality of life and do not wish to live our lives in debt peonage, and further, to sell the lives of those not yet born into this same form of slavery, we MUST put a stop to this NOW. It is our moral duty and obligation, and respect for the inherent dignity within each and every human being DEMANDS that we act.

Excellent rant.

from his Monday, August 31. 2009 blog:

http://market-ticker.denninger.net/archives/P4.html

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.

See what lawless behavior gets you folks?

You start this crap - selling worthless paper, intentionally turning a blind eye to fraud, profiting from fraud, screwing consumers and foreigners alike and guess what?

BINGO! A foreign government that runs a command economy says "Ok, you think that was cute? Try this!"

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.

Oh, so our wonderful banks have been over there peddling their junk in Beijing too eh? Derivatives you say?
I love it.

We reap what we sow, and may the "foreign banks" (you know this includes some nice juicy ones over here in the US) get stiffed and stuffed.
I have no sympathy - zero - for the IBs who get burned by this.

Now let's see China grow a pair of brass church bells and tell Geithner and company to stick it on their debt sales - or even better, why not sell?

If our government refuses to do the right thing and acts like Tony Soprano, then perhaps we need a bigger, badder, more powerful gang to come smack our government around a bit.

but they are not recent innovations. If a big player can simply walk away from a trade with impunity, doesn't that undermine the whole futures trading system? The commodities markets would collapse. Are Chinese firms really prepared to buy commodities on a cash and carry basis only? Or a I reading too much into this?

Damned straight it does. The same rules that apply to COSCO and Air China for their fuel purchases apply to the Johnson Family Farm in Iowa when they are trying to get the best price for their wheat for delivery in November.

If large players start to ignore the rules, probably.

That's it, isn't it?

Unless I am completely out in left field here, I submit the following illustration;

The PSCOT Shipping Company of Shanghai uses Diesel. You as CFO know that your fuel needs for the first quarter of 2010 are going to amount to something on the order of 500,000 tonnes of fuel. Let's say diesel is currently selling for $1,500/tonne from your favorite distiller, Royal Dutch Shell out of Rotterdam. You think $1,500 is a fair price based on what has happened to fuel prices over the course of the last 24 months so you enter into a contract for delivery in early January of 2010 for a half million metric tonnes (about a full tanker load).

The refinery in Rotterdam has yet to receive the shipment of crude. They get it in mid November (Having paid on a contract signed in perhaps April) along with orders from other major customers and start refining your diesel as well as kerosene, gasoline and the other fuels they have on order as soon as they have the cat cracker available later that month. The shipping time is 28 days or so from Rotterdam to Shanghai. They load the tanker on the 2nd of December

Payment is due to RDS when the fuel hits your storage tanks in Shanghai, i.e. on delivery and it will be made via wire transfer from your bank in Shanghai or Hong Kong to their bank in Amsterdam.

What if the price of crude plummets between now and January.
What if the price of crude skyrockets in the same period?
What if the tanker is hijacked by Somalian Pirates as it passes through the Gulf of Aden?
What if the tanker runs aground as it passes through the Strait of Malacca?

All of the above would affect the value of your fuel and the contract you entered into for its delivery and all of it is well within the realm of possibility. You would want to protect yourself from any and all of these possibilities. You could do so by hedging your contract by various means. If all goes well and you get your delivery on time and in good order, would the cost of say - buying an option on a delivery for a half million tonnes of fuel for delivery the second week of January instead of the first week be justified? Since you entered into such a contract in order to protect yourself from the possible adverse outcomes, should you be allowed to simply not pay or settle on them?

If there were no mechanism for you to lock in a price now for delivery later, your fuel purchases are subject to the daily price fluctuation of the market. If during the 28 day transit from Rotterdam to Shanghai the spot price of diesel spikes by $100.00/tonne, it could be financially devastating. If there were no way to have a contingency in place (an option) to replace that fuel should it get hijacked/lost at sea/run aground, you would be fucked.

The Chinese entities in question made contingency bets that they lost on and now don't want to pay.

That's fucked up, any way you look at it.

I've sold naked puts on fuel oil. Ive hired Lithuanian gangsters to hi-jack the ship. I'll secretly sell the oil on the spot market, collect on my insurance claims and make a fortune on the puts when fear of piracy drives the fuel price up. What could possily go wrong?

:spray:

Sounds perfect.

But when the very same people who sell those derivatives are also in a position to manipulate the markets to which those very same derivatives apply (and we have explicit confirmation of this), that is called fraud. Those contracts were made in bad faith, not by the Chinese companies, but by the Western banks which sought to take advantage of them.

People who desire to take things from others, not in exchange for goods or services but by deceit and bad faith dealings, deserve nothing at all.

It would just be like cancelling some poor bastard's health insurance when he discovered that he had cancer.

A black swan by definition is something that can't reasonably be predicted. Chinese mercantilism is not only predictable, it is probable.

And if we were smart we'd have the same exact trade policy - we trade for OUR benefit, full stop. Others may trade with us if you think it is to their benefit.

The Chinese realize that they're in a position of strength now, compared to the US. This comes right on the heels of them also deciding to ban all exports of rare earth metals -- of which they currently supply 90% of the world's supply. These are the same metals needed to construct hybrid and electric vehicles.

So much for the recovery....

First-This has ZERO to do with exotic CDOs, CDS, CMOs, and only involves some plain vanilla commodity hedges. "Derivatives" covers a broad range of products and includes plain old futures and options ... Which seem to be the products involved here. Apparently the Chinese don't repudiate all derivatives, just the ones they lose money on. They just want the right to pick up thier losing bets from the table just before the croupier sweeps them away. Who wouldn't.

Second- as Heretic points out, we are talking about huge Stare Owned enterprises. If a Western bank calls the CFOs or Treasurers office at one of these firms, presumably the person who picks up the phone there knows what they are doing. It's one thing for a trader to pick off some fly-by-night Iclandic bank. But at a Chinese S O E, I would assume that they know their ass from their elbow. So I don't buy for a second that the big bad banker/broker picked off some hapless Chinese functionary.

Third-we don't know that the firms the supposed "renege" letter were Goldman, Morgan et al. The article makes clear that the names of the firms are as yet undisclosed. The author went to Goldman/Morgan for comment because they are "the usual suspects". Butnothing in the meat of the piece names them.


My own guess is that this involves China's failed attempt to buy Australia based iron ore producer Rio Tinto. Shortly after the most recent failure if China's Chinalco to acquire alarge chunk of Rio Tinto the Chinese arrested four Rio Tinto employees and charged them with stealing state secrets.

I think that this "renege" letter - if real - will have been directed to Australian banks. Perhaps the banks involved in the failed Chinalco/Rio Tinto deal as well. The Chinese can be petulant. And they try to punish failure.

Probably all part of Chinese trying to muscle the price of iron ore and other commodity input prices lower.

A good size flock of angry nasty hissing aggressive geese. The kind that have been kept in the courtyards of Chinese' farms for centuries.

Their purpose is multi fold. Food is number one. Barter is number two. Showing one's wealth, third. The best natural early warning system when ever that need arises, slides into any of the first three slots.

In short, if the geese raise the alarm, you the intruder can expect a painful encounter. Shoot first, ask questions later. So you get an ass full of bird shot. Bet you won't try that again.

China has many problems. Subsidizing their economy's consumption of fuel and food to keep the masses under control is a very big one.

Allowing traders to run up the market (commodities, stocks, what ever) is our (western) problem. How many times has the Chinese government pulled the plug on speculation in their stock market? Added money and tell the banks to lend, then just tell their banks to stop lending? They just put down a rebellion in western China. New pipeline going into Burma. Then on ward to south China. Iron fist in a silk glove.

The warning is pretty clear. The geese have raised the alarm.


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