How J.P. Morgan Got Tangled in a $500 Million Derivatives Debacle
Source: Bloomberg, Jan.24, 1999

Just over a year ago, on the first Sunday of 1998, a J.P. Morgan & Co. executive answered the telephone in Room 1808 of the Hotel Shilla in Seoul. Bang Choon Ho, a Morgan vice president, had flown to the South Korean capital from Hong Kong to persuade eight financial companies to swallow a $757 million trading loss.
If the Korean firms didn't pay -- and it didn't look like they would -- then Morgan, the fourth-largest U.S. bank in terms of assets, would be on the hook for an amount equal to half of the $1.465 billion it earned in 1997.
At issue then -- as it still is today -- was who should bear responsibility for a series of derivatives trades that had gone wrong. Would it be Morgan, which had brokered the transactions and offered its clients the prospect of a 30 percent return? Or would it be the Korean firms, which had invested the money and taken the risks?
Just after 3 p.m. on Jan. 4, 1998, Bang listened as Song Jae Ho, another Morgan vice president, urged him to shut down the investments. Speaking Korean, Song pleaded with his colleague not to let the clients try to trade their way out of trouble.
"I don't think restructuring would work," said Song in a conversation that was tape-recorded by J.P. Morgan. "Kurom!" ("Right!") replied Bang. "You bet when you're making money," Song said, "never when you're losing money."

Who Will Pay?
A year later, Morgan is still trying to contain the damage from its misadventures in Korea. The New York bank has set aside $500 million to cover any liability from the soured trades.
That amount represents the money still due after two Korean banks paid up on part of the losses. The potential damage dwarfs the $165 million hit taken by Bankers Trust Corp. in 1996 in a landmark derivatives dispute with one of its clients, Procter & Gamble Co.
Morgan's bottom line is already smarting from other trading losses. Its profit fell 34 percent last year to $963 million, the worst result since 1989. Analysts view the New York bank as a prime takeover target.
Morgan's clients bet big in Korea, chasing double-digit returns with what looked like little risk. The Korean trades blew up after one Asian currency, the Thai baht, plunged 18 months ago, detonating a chain reaction of devaluation, bankruptcy, default and trading losses that rocked not just Morgan and its clients but banks and securities firms around the world.
Did the Korean firms enter into these investments as consenting adults? Or did Morgan somehow dupe them? Morgan and the Koreans are arguing over these questions in nine separate lawsuits in Seoul and New York.
Bloomberg News reporters listened to 40 of the 460 tapes that Morgan submitted to a U.S. District Court in New York in connection with two of these suits. The conversations, in Korean and English, run about five and a half hours.
Like many U.S. banks, Morgan routinely tapes telephone calls to maintain a record of client trades and to check that employees are complying with regulations. The bank recorded these calls between September 1997 and February 1998, a period when the Korean trades were hemorrhaging money.

'Casino Financing'
Beginning in January 1997, Morgan arranged seven derivatives investments for five Korean clients -- a securities firm, an insurer and three investment companies. In addition, three Korean banks played a role in guaranteeing the trades.
All seven transactions consisted of a web of interlocking trades involving three currencies: the U.S. dollar, the Japanese yen and the Thai baht. At least two of the transactions also involved the Indonesian rupiah.
Morgan called them the "Promax Deals," for "Profit Maximization." For the U.S. bank and the Koreans, the only thing these trades have maximized so far is trouble.
Two of the Morgan executives responsible for the trades are out of a job. One of Morgan's clients, Shinsegi Investment Trust Co., has been forced out of business. Another client, Hannam Investment Trust Co., went broke and was bought by a rival.
The Korean firms suing Morgan say the U.S. bank didn't adequately explain the risk of derivatives. "These deals should have been labeled 'casino financing,'" said David Yu, the general counsel of Housing & Commercial Bank in Seoul, which guaranteed three Promax Deals.
Morgan's response to all the plaintiffs: A contract is a contract. "The Korean institutions entered into valid, binding contracts for transactions that were, in some cases, proposed by them and structured to meet their specific business objectives," said Joseph Evangelisti, a bank spokesman.
Morgan Chairman and Chief Executive Douglas "Sandy" Warner III and other senior officials declined to be interviewed.

Morgan Feels Pain
J.P. Morgan, founded 138 years ago by legendary financier J. Pierpont Morgan, has been trying for a decade to transform itself into a Wall Street-style investment firm. The results are mixed.
Its return on equity -- which averaged 14.8 percent in the past five years -- is nowhere near the 24 percent posted by Merrill Lynch & Co., the largest U.S. securities firm. Morgan has, however, managed to become a leader in one area of the securities business -- derivatives. These investments are contracts between two parties whose value can be tied to price changes in stocks, bonds, currencies, commodities or virtually any combination of those things.
The Bank for International Settlements estimated the "notional" amount of derivatives worldwide at $70 trillion as of June 30. That figure represents the value of the assets that underlie these contracts, not the amount that banks and other parties actually have at risk.
The notional amount of Morgan's derivatives has grown 40 percent per year since 1991, reaching $8.64 trillion by Sept. 30. The bank ranks third in the worldwide derivatives market, behind Chase Manhattan Corp. and Citigroup Inc., according to Swaps Monitor, an industry newsletter.

Enter Dr. Chi
The Promax story begins in 1996. Asia was booming, and the Korean economy was a standout performer. From 1992 to 1996, Korea's gross domestic product expanded at an average annual rate of 7.3 percent. The prime rate, the interest banks charge their best customers, stood at 9.5 percent.
Korean financial firms were in a bind. Their cost of funds was rising, and their customers were defecting to the international capital markets, where money was cheaper. The Korean firms asked foreign banks for help. And Morgan, which had maintained a liaison office in Seoul since 1986, was eager to cooperate.
In November 1996, Morgan dispatched to Seoul a Hong Kong-based vice president named Chi Chang Hyun. Now 38, Chi (pronounced CHEE) had, by his own count, orchestrated some 100 derivatives trades in the past decade.
A Korean national whose father was once ambassador to Italy, Chi holds a Ph.D. in economics from George Washington University in Washington, D.C. Engaging and witty, he is known by friends and colleagues as Dr. Chi.
Chi outlined the Promax Deals in a one-page, handwritten letter faxed to SK Securities Co., a Korean securities firm, on Nov. 14, 1996. He proposed that SK Securities boost its returns through a trade he called a "yen loan hedged with baht."

A 'Synthetic' Loan
But Chi's trade wouldn't actually be a loan, and SK Securities wouldn't actually hold any yen or baht. Instead, Morgan would use derivatives to mimic the kind of low-interest loan SK Securities would get if it were to borrow yen at the prevailing rate of 2 percent from a Japanese bank.
Why didn't SK Securities, a subsidiary of the SK Group, Korea's fifth-largest conglomerate, just go to a Japanese bank and borrow yen? With a standard yen loan, SK Securities' repayment costs would rise if the won, the currency in which it kept its accounts, weakened.
Chi had a plan to avoid that risk, one that would enable SK Securities to borrow money and invest it with a single transaction. What Chi offered the Seoul securities firm was one-stop shopping.
Using algebraic equations, he sketched a formula that involved the dollar, the yen and the baht. It would, Chi said, effectively cut SK Securities' borrowing costs by 4 percentage points. In derivatives lingo, this was a "synthetic" loan.
Chi said in an interview on Jan. 14 that he had never structured a deal like this before, one where the Thai currency was the linchpin. For his plan to work, the baht, pegged since 1984 to a group of currencies that included the dollar and the yen, would have to hold fast. If the Thai currency fell, the Koreans could lose all the money they invested -- and more.

The Tremors Start
Dr. Chi had a further prescription for SK Securities. The Korean firm could use the synthetic yen loans to buy notes tied to the Indonesian rupiah.
Put the two things together, the yen/baht formula and the rupiah notes, Chi told the Koreans, and you can achieve an annual return of about 30 percent, paid in dollars. That's what his fax said: 30 percent.
Chi saw little risk that the baht would come unstuck. In the 12 years that the Thai currency had been pegged, it had fallen against the dollar in seven -- but by an average of just 0.8 percent. During that time, Thailand's GDP was growing at an average annual rate of 8.7 percent.
"We can see stability in the Thai economy and the baht," Chi said in a note faxed to Korea First Investment Trust Co., another investor in the Promax Deals, on Nov. 16, 1996.
Just a few weeks later, the tremors started in Thailand. Its economy, one of the fastest-growing in the world, was becoming overbuilt, overheated and overleveraged.
Thai banks had trouble collecting money on property loans, causing investor confidence to wane and the baht to weaken. It fell 0.5 percent in December, its steepest monthly decline in almost a year.

Total Return Swap
As the Bank of Thailand tried to defend the baht by buying it on the open market in early 1997, Chi arranged the first five Promax Deals -- all dependent on the now-wobbly Thai currency.
Here's how one of the deals for SK Securities worked: Morgan helped SK Securities establish a trust in Labuan, Malaysia, a tax haven modeled on the Cayman Islands. The trust was called Advanced Investment Ltd.
Morgan used its own shell company, a "special purpose vehicle" called Frome Co. incorporated in the Channel Islands, to borrow money in the international capital markets -- at rates of about 5.5 percent.
Frome invested $50 million in Advanced Investment. SK Securities and several partners invested $24 million in the trust.
Advanced Investment used all $74 million to buy one-year rupiah notes underwritten by Morgan. The redemption value and yield on these notes rose and fell with the rupiah/dollar exchange rate.
Morgan and Advanced Investment then entered into an agreement known as a total return swap.
In the contract, signed by Chi and an executive at SK Securities, Morgan pledged to pay the trust the redemption value plus interest -- the total return -- on its $50 million investment in the rupiah notes when they matured on Feb. 20, 1998.
In exchange, SK Securities' trust promised to pay Morgan a lump sum of $48.5 million on the same date.

'Taking the Bait'
It looked like Morgan would be out at least $1.5 million after a year. But SK Securities' lump-sum payment to Morgan was only one piece of this Promax Deal.
SK Securities would owe Morgan additional money if the baht weakened against the dollar. That amount would be calculated according to Chi's yen/baht formula, which was augmented by another element commonly used with derivatives: leverage.
The Korean firm would have to pay Morgan five times the percentage decline in the baht multiplied by the $50 million face value of the synthetic loan. If the baht fell by just 2 percent, for example, SK Securities would owe Morgan $5 million on this part of the transaction.
The Korean firms, lured by the prospect of a 30 percent return, may not have understood just how vulnerable they were to even a slight move in the baht.
"Korean financial institutions took the bait without a second thought," said Song Ki Gyoon, a general manager of Hannam who joined the investment firm after it signed a Promax contract and cautioned his bosses about the firm's exposure.
Why did Morgan orchestrate a baht-dependent transaction in such a climate? Because the clients asked for it, the bank says.
"The disputed transactions were arranged at the request of SKS and modeled on deals it had been offering to Korean investors long before it approached us," said Evangelisti, the Morgan spokesman.

Money Up Front
SK Securities had pitched similar derivatives to its own customers before hiring Morgan. But these trades had a built-in brake -- investors could lose all the money that they had put in but no more than that. The Promax Deals offered no such protection.
Morgan itself wasn't taking a gamble on the Thai baht. Its customers were. Wall Street banks typically sit on the fence in swaps, hedging their risks with offsetting trades.
Morgan stood to make money at the front end of the transactions. It expected to collect as much as $10 million in fees and commissions for arranging the Promax Deals.
In all, Morgan's offshore company, Frome, invested $275.5 million in seven trusts. In addition to SK Securities, four other Morgan clients -- Hannam Investment, Korea First Investment, Shinsegi Investment and Korea Life Insurance Co. -- set up trusts in Labuan for Promax Deals.
Morgan did face the risk that it would get saddled with losses if its Korean clients refused to honor their Promax contracts. So the U.S. bank asked its customers to buy insurance.
Three Korean lenders -- Boram Bank, Housing & Commercial Bank and Korean Exchange Bank -- provided letters of credit or other guarantees of the payments by Morgan's clients. SK Securities paid Housing & Commercial about $370,000 to guarantee the $74 million Advanced Investment transaction.

Snarled Parachute
The crisis in Thailand was now in full throttle. On March 3, 1997, the Bangkok stock exchange suspended trading in all banks and finance companies. Two weeks later, Morgan completed the sixth baht-dependent Promax Deal.
By now, Morgan's own analysts were eyeing Thailand with concern. In April, the bank issued a report warning that Thailand's 13-year-old currency system was "vulnerable."
Still, Chi and his Korean clients pressed on. They signed the last Promax Deal in the third week of June. On July 2, the Bank of Thailand stopped defending the baht. The currency tanked, plunging more than 19 percent against the dollar in a single day.
Within hours, SK Securities faced a potential loss of $50 million on the baht portion of its Advanced Investment deal. The other Promax Deals were bleeding, too. And the baht kept falling.
An executive at a bank that guaranteed two Promax Deals likened the baht's collapse to a skydiver's parachute getting snarled.
"It's a million-to-one chance, but when that parachute doesn't open up, you're dead," said Ahn Joong Suk, a deputy general manager at Korean Exchange Bank.
For Morgan's clients, the baht was just the first blow. Other Southeast Asian currencies collapsed, including the rupiah.

'Written With Tears'
By Aug. 15, the baht had fallen 30 percent against the dollar. SK Securities's currency loss had climbed to $75 million. Struggling to contain the damage, Morgan executives mapped out their choices in a memo.
They could unwind all or part of the Promax trades, renegotiate the contracts or let their clients hang tough with the original terms in the hope that the baht would rebound.
In the following weeks, Chi desperately tried to sell his clients' baht positions, but he had trouble locating buyers -- at any price.
"I was horrified to see the liquidity today," Chi told a colleague in a tape-recorded telephone call on Sept. 30. "It was OK until a few days ago. We have a big problem now." By this time, the baht had tumbled 48 percent against the dollar, bringing SK Securities' currency loss to $120 million.
Later that day, Chi pressed an official at Korea Exchange Bank to tell him whether it would accept renegotiated terms on its guarantee of two Promax trades.
"We have to make a decision by the end of October," Chi said. "I will send you a fax written with my tears."
By now, shocks from the Asian currency quake were reaching Korea. The benchmark Kospi stock index tumbled to a five-year low of 579 on Oct. 16. That month, the government shut a dozen money-losing lenders. On Nov. 12, the Ministry of Finance issued a statement saying Korea was "no Thailand."

'Take More Risk'
That same day in New York, Morgan CEO Sandy Warner issued a memo of his own. In a three-page letter entitled "Aspirational Plan," Warner told executives that Morgan had now built up its investment banking business to the point where it could seek "rapid returns" in derivatives and emerging markets.
How, in the face of the chaos spreading through Asia in late 1997, could Warner have expressed such confidence in emerging markets? Morgan executives smelled opportunity. They thought they could take advantage of the turmoil to elbow aside rivals.
To one Morgan vice president involved in the Promax Deals, the meaning of Warner's message was clear.
"I read the Aspirational Plan," Lynn Hopkins, a Tokyo-based credit manager, told Chi in a telephone call on Dec. 9.
"To me, it said: 'Take more risk, make more money.'" It had been Hopkins's job early in 1997 to decide whether the three Korean banks were strong enough to guarantee the Promax Deals. Now, she was working with Chi to get the banks to pay up. She urged her colleague to have faith. He was, she said, "a man of steel nerves."
The situation in Korea worsened. On Dec. 3, the International Monetary Fund arranged $57 billion in emergency credits and loans for the Korean government.
Morgan's exposure on the seven Promax Deals reached $757.1 million on Dec. 29, 1997, according to a Morgan document. The slide in the baht accounted for $504 million of that red ink.

Exit Dr. Chi
Morgan management ordered its bankers not to lend another dime to Korea. The bank also removed Chi as the point man on the Promax Deals, replacing him with an executive who hadn't had any connection to the trades -- Bang Choon Ho.
It was Bang, now 37, who picked up the telephone in the Hotel Shilla on that Sunday afternoon in Seoul last January. Speaking Korean, Bang told his colleague, Song Jae Ho, that Chi should have pulled the plug on the Promax Deals six months earlier and cut his clients' losses.
"Dr. Chi kept on saying the Thai baht would stabilize, even to me," Bang said. Breaking into English, he said Morgan executives believed Chi was "mentally collapsed."
Bang worried -- presciently, as it turned out -- that the Promax Deals would become a legal quagmire for Morgan. "'Legal' says this could possibly become another Procter & Gamble," Bang said.
He was referring to one of the biggest derivatives debacles ever. Procter & Gamble, the largest household products company in the U.S., lost $200 million on derivatives arranged by Bankers Trust. P&G sued, and in May 1996, Bankers Trust agreed to swallow $165 million of the loss.

Lawsuits Mount
Morgan's own legal troubles began last February when SK Securities sued the bank in Seoul. In a separate suit filed in New York, the Korean securities firm alleges that Morgan officials believed the baht would collapse and "deliberately misled" their clients.
Morgan must defend itself in five other lawsuits brought by Korean customers and banks. The U.S. bank, in turn, has sued SK Securities, Hannam Investment, Boram Bank and Housing & Commercial Bank for breach of contract.
Lawyers for all the parties are now trying to settle the disputes out of court. Cases this complicated rarely go to trial.
In Korea, the Promax Deals have exacted a heavy toll. Shinsegi Investment Trust collapsed in December 1997, its assets sold off by creditors. Hannam Investment became insolvent last August and was bought by Citizens Investment Trust Co., a unit of the Hyundai Group.
In advertisements published in Korean newspapers in November, SK Securities apologized to customers and shareholders after losing $372 million in the past three years. "We put growth ahead of stability," the firm said.
Korean regulators threatened to shut down SK Securities but allowed the firm to stay in business after its parent, SK Group, invested $190 million. Morgan says the securities firm owes it $340 million on Advanced Investment and another Promax Deal.

'Wildest Dreams'
At Morgan, the fallout from the Promax Deals has hit more than the bottom line. Lynn Hopkins, the executive who believed CEO Warner was urging his troops to take more risks, is no longer working at Morgan. But the bank is still paying her salary. Now living in New York, Hopkins has hired her own lawyer. She declined to be interviewed.
The man at the center of the Promax storm, Chi Chang Hyun, resigned from J.P. Morgan on Dec. 31 after spending most of the year on paid leave. Dr. Chi said in his Jan. 14 interview that he had been stunned by the descent of the Thai currency.
"I never imagined the baht would collapse, not even in my wildest dreams," said Chi, smartly dressed in a navy suit and red tie.
The former executive, who still lives in Hong Kong, said he plans to work as a consultant for Korean firms in financial distress until he lands another full-time job with a bank or returns to academia as a teacher.
"I should know something about distress," Chi said, laughing. He also wants to write a book about the "lessons to be learned" from the Promax Deals.

The Promax Lessons
And what might those lessons be? Chi won't say. And neither, for that matter, will anyone else involved in the Promax Deals. Morgan officials insist the their Korean debacle hasn't prompted them to reevaluate the way they structure deals, relate to clients or manage risk.
While Morgan hasn't crafted any new trades exactly like the Promax Deals, the bank is still pushing hard in derivatives and emerging markets. And it's still paying the price.
On Jan. 14, Standard & Poor's Corp. placed the AA credit rating of Morgan on a "negative outlook," a step that often presages a downgrade. For Morgan, "emerging market problems come on top of losses in trading operations and other strategic issues," S&P said.
While the Promax Deals have devastated some of Morgan's clients, the bank itself says it has suffered no lasting damage in Korea.
"Our position in Korea is stronger than ever," said Evangelisti, the bank's spokesman. The Seoul government granted Morgan a full banking license in July, allowing the bank to underwrite stocks and bonds. Morgan Guaranty Trust Korea Co. opened in October -- with Bang Choon Ho, the man in Room 1808 of the Hotel Shilla, at the helm.