What could be common between Barings Bank, Long Term Capital, Berkshire Hathaway and Indian companies such as ICICI bank, Wockhardt and Varun Shipping? All these companies have, in some way or the other, found themselves on the wrong side of derivatives.

Warren Buffet in his letter to the shareholders in 2003 had described derivatives as financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. While Buffets worst fears appear to have come true in the global corporate arena, its repercussions have begun seeping into the Indian corporate world.

The latest earnings numbers of Indian corporates have brought to fore the marked increase in loss provisioning by banks, mark-to-market losses and forex losses on overseas loans by corporates.

What are these losses and how significant are they? Are the losses recurring or would a one-time provisioning for them suffice? And most importantly, is the worst over or are these losses here to stay? Here are a few takeaways from the trends available so far.

Derivative losses for Indian companies can broadly be classified under three heads:

Forex losses arising out of revenue exposure to foreign currency (hedging direct business exposure or forex denominated overseas loans),

Provisioning of likely losses by banks to cover the risk of non-payment by corporates that have borne huge derivative losses.

Losses provisioned for by banks that have direct exposure to some of the overseas credit derivatives that have notoriously suffered de-rating after the sub-prime rout made its presence felt.

Loss provisioning

While there is no mandate at present that requires companies to divulge relevant details about their derivative exposure, we will be getting there soon. The ICAI had recently asked companies to mark-to-market all outstanding derivatives contracts on the balance sheet with effect from FY08 onwards.

Notwithstanding this, ascertaining the exact amount of derivative exposure of companies is difficult. The extent of increase in loss provisioning by banks, however, may offer a few clues. Most of the banks in their March quarter results have provided for losses. This will be used to cover for losses the banks might suffer, if their clients fail to meet their payment obligations on their derivative contracts.

For instance, State Bank of India has provisioned against the forex losses of it clients, which are in the range of Rs 600-700 crore. Kotak Mahindra Bank has provided for over 45 clients with exposure to forex derivatives. Its clients have incurred MTM losses of Rs 612 crore .

To that extent, the mark-to-market provisioning by some of the top Indian banks such as ICICI Bank, SBI, Axis Bank and Kotak Mahindra Bank against their clients exposure to various derivative transactions has been pegged at over $175 million (about Rs 700 crore). Mark-to-market losses are arrived at by valuing the derivatives at their prevailing market price.

Hedging losses

On the corporate front, however, there may be many skeletons in the cupboard. What began as an initiative to reduce borrowing cost or hedge against currency risks in revenues has landed many small and medium-sized companies in trouble.

While the larger companies, with a strong treasury team and a better understanding of the derivatives market have gotten away with lesser losses (or made no noise about it), the smaller ones bore the brunt. Companies such as Rajshree Sugars, Himatsingka Seide and Sundaram Multi Pap have reported significant losses and have taken their banks to courts.

Seasoned players such as the big IT companies also suffered losses on account of hedging transactions. Typically companies in the IT sector, hedge their dollar or Euro realisations against any undesirable appreciation of Indian rupee vs. the foreign currency.

While in June last year, IT companies paid heavily for underestimating the rupee power (rupee had appreciated considerably against the dollar), this time around, they took a hit by pegging the rupee value too high against the dollar (rupee has depreciated during the period).

This wrong estimation of the rupee levels forced some of them to provide for the mark-to-market losses. Infosys Technologies provided for Rs 28 crore MTM as hedging losses; KPIT provisioned for Rs 90 crore while Satyam Computers provided for Rs 46 crore.

Telecom major Bharti Airtel recorded a MTM loss of Rs 204 crore, which also includes provisioning towards other derivative transactions.

Companies with forex denominated overseas loans have also provided for MTM losses. The unexpected depreciation in rupee vs. dollar and even the Swiss franc and Euro vs. dollar last quarter resulted in forex losses for companies across sectors.

For instance, Firstsource had raised $275 million in November last year, when the rupee was at 39.5 to the dollar. However, with the rupee weakening last quarter, the convertible bonds had to be re-stated and the difference was taken as MTM loss. Similarly, Maruti also made a loss provision of Rs 50 crore recently against forex losses incurred on forward Euro contracts on exports as well as an external commercial borrowing.

Adding to the derivative woes, some banks have also seen a significant depreciation in the value of securities they hold in overseas market.

The emergence of the sub-prime crisis and the ensuing widening credit spreads (the difference between yields on corporate bonds and treasuries) in the international markets on the back of high default-risk depreciated the value of their investments.

For instance, State Bank of India provided for Rs 40 crore in 2007-08 against such losses, while ICICI Bank had in the previous quarter provided for $100 million towards MTM provisioning for credit derivatives.

Loss provisions enough?

Note that companies have provided for MTM losses based on the market value of the derivatives in consideration as on March 31. So, in essence the actual losses from such exposures can now either be higher or lower than what has been provided for.

The loss provisions would be enough as long as the value of the derivative or the market value of the underlying assets remains stable (or moves in the expected direction).

On the contrary, any drastic movement of the underlying against the hedged position may require a lot of money by way of margin calls. Failure to meet the margin money obligations can force banks (that helped the corporates transact) to cut their clients derivative positions well before expiry.

This can multiply the losses for corporates, which were anyway holding out-of-money positions. However, some companies may have also unwound the transactions and booked losses, in which case there may be no further losses booked in future. But such companies will also not gain from any movement in the opposite direction.

The banks, on the other hand, may face a higher risk of default by their corporate clients and likely reduction in fee-base income as the exotic forex products may be viewed with more scepticism.

For companies that have borrowed in foreign currency or swapped their debt in other currency, the MTM losses will remain a function of the currency movements.

Depreciation in Swiss franc and Japanese yen vs. the dollar (typical currencies that saw currency swaps last year) over the last fortnight, which would have provided relief to companies that had earlier provided for high MTM losses is a case in point.

In the case of IT companies, hedging losses, to an extent may be made up by translation gains; operating profit margins may expand proportionately.

What the future holds

For certain, the future will see fewer companies enter derivative contracts for mere speculation. With the ICAI recommending companies to mark-to-market all their derivatives instruments and provide for the gains or losses in the P&L (or mention in notes to accounts); the disclosure norms appear set to improve.

When FAS133 (standard for financial reporting of derivatives and hedging transactions) was introduced in the US it sharply reduced the sales of exotic derivatives in global markets.

However, over time, the sales picked up, more due to the utility of these products than the mere speculative thrill they offered. India may also see a similar revival in the forex derivatives market, after an initial slump.

Not taking the optimism too far, it can be safely assumed that improved disclosure norms would see lower speculation and lesser uninformed participation in this market.

That notwithstanding, hedging and forex losses may be here to stay. Their quantum, however, may reduce over time.

Trends to watch out for

From an investor standpoint, it may be best to avoid companies that have indulged in derivatives for mere speculation. Watch out for companies that have reported:

Significant reduction in interest cost when compared to either their own historic cost levels or against peers.

Considerable increase in income, with a significant contribution by other income. Look out for any steep increase in export income caused merely by forex gains.

Forex losses that have been reported as extraordinary expenses, which is often overlooked by investors.