Chinese to destroy Feds by refusing to honor fraudulent derivatives contracts

UPDATE 1-Beijing's derivative default stance rattles banks
Mon Aug 31, 2009 7:42am EDT

* State-owned firms may default on commodity hedges - report

* Bankers dismayed, confused by report; seek more details

* Lawyers question legality of the move

* Traders suspect lurking losses may have prompted warning (Adds analysts comments)

By Eadie Chen and Chen Aizhu

BEIJING, Aug 31 (Reuters) - 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 on 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 (GS.N: Quote, Profile, Research, Stock Buzz) and UBS (UBSN.VX: Quote, Profile, Research, Stock Buzz) declined comment, and media officials at Morgan Stanley (MS.N: Quote, Profile, Research, Stock Buzz) and JPMorgan (JPM.N: Quote, Profile, Research, Stock Buzz) 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 re-negotiate," said a second banking source. "It's outrageous, but it's China, so everyone is treading very carefully."

DAMAGING PRECEDENT

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.

The report follows an order from SASAC in July that required all central government-controlled state companies engaged in trading derivatives to make quarterly reports about their investments, including details of holdings and performance.

But the reported letter opened several important questions that could not immediately be answered.

"If we were among the banks receiving that letter, we would be very angry. But now the key is to find out more details on the letter: In whose name the letter was issued, the government or the corporate's? And under what was the reason for defaulting?" said a Singapore-based marketing executive with a foreign bank.

The source, whose bank did not receive a letter, said that Air China, China Eastern and shipping giant COSCO -- among the Chinese companies that have reported huge derivatives losses since last year -- had issued almost identical notices to banks.

"If it's in the name of the government, the impact will be very negative," said the source, who declined to be named.

Beijing-based derivatives lawyers said the so-called "legal letter" has no legal standing -- SASAC as a shareholder has no business relationship with international banks.

"It's like the father suddenly told the creditors of his debt-ridden son that his son won't pay any of his debt," said a lawyer from the derivatives risks committee of the Beijing Lawyers Association.

It's also unclear why Chinese state firms, which have complained that their foreign banks sometimes did not disclose full information of potential risks when selling them complicated products, did not seek redress through the courts.

"If that is the case, these firms should seek through legal measures to safeguard their rights, instead of turning to the authorities for political interference," said a different lawyer.

SASAC took over the job of overseeing SOEs' derivatives trading from the securities regulator in February after several Chinese firms reported huge losses from derivatives.

For a factbox of China's derivatives debacles:[ID:nPEK206094] (Reporting by Eadie Chen and Chen Aizhu in Beijing, Alfred Cang in Shanghai, George Chen and Michael Flaherty in Hong Kong; Editing by Jonathan Leff)