Orange County, Calif.
The county treasurer, Robert Citron, borrowed $14 billion in 1991 and invested it in complex derivatives contracts, primarily with Merrill Lynch & Company. According to The New York Times, this sort of practice became common sometime after 1978, "when California enacted Proposition 13, which cut property taxes," thus leaving municipalities with a revenue gap.
Returns were solid for several years. Things turned sour, however, when the Fed began raising interest rates in 1994. In December of that year, the county announced that it had lost $1.5 billion of its total investment funds and couldn't make its securitized loan payments to First Boston Corp. The investment bank then liquidated its collateral holdings with Orange County. On Dec. 6, Orange County filed for bankruptcy -- it was the largest filing by a municipal entity in American history.
The market responded quickly; BusinessWeek reported that "prices in the $1.2 trillion municipal bold market sank more than a full point. … Treasuries took a hit as well, with the Dow Jones industrial average declining 10.43 [points]."
A flood of lawsuits followed. By 1998, Merrill Lynch had paid over $70 million in lawsuit settlements with Orange County and in SEC fines. Citron pled guilty to several counts, including misappropriating funds and failing to transfer public funds, and received a one-year prison sentence.
By most standards, Proctor & Gamble had a good financial head on its shoulders. According to BusinessWeek the company "seemed to be an active and sophisticated player in the financial markets: It had $5 billion in long-term debt outstanding, and it carefully managed its financing costs." So when Proctor & Gamble invested in two complex derivatives products with Bankers Trust, one of the largest banks in the United States in the early '90s, there was little cause for concern.
Then, on Feb. 4, 1994, the Fed raised interest rates for the first time in half a decade. A few weeks later, Bankers Trust informed Proctor & Gamble that its interest rate on one of the derivatives -- the 5/30 swap, in which the writer of the option, in this case Proctor & Gamble, is left entirely exposed to the market -- had been raised 4.5 percentage points. By the time Proctor & Gamble locked interest rates on both its derivatives -- and after the Fed raised interest rates several more times -- the company owed Bankers Trust $195.5 million more than predicted.
By this time, several other companies had also lost large amounts with Bankers Trust. Gibson Greetings Inc., for example, lost upwards of $23 million and sued the bank in 1994. In a settlement later that year, Gibson Greetings paid Bankers Trust $6.2 million, roughly 30 percent of what it owed the investment bank.
News of Proctor & Gamble's losses shook the industry. Former BusinessWeek journalist Kelley Holland told FRONTLINE that the fact that a financially savvy company like Proctor & Gamble was hit with such losses was "an early indication that there were potential problems with these instruments, that they were complicated, that their value could change quickly and that they were sold and bought in an environment that was not closely monitored."
Proctor & Gamble took Bankers Trust to court alleging the bank convinced the company to purchase complex derivatives, misrepresented the value of these products and, when Proctor & Gamble suffered losses or gains, pushed the company to purchase more derivatives in order to continue or reverse the given trend. In 1995, RICO [Racketeer Influenced and Corrupt Organizations Act] charges -- most famously used to prosecute mobsters -- were added.
As part of the lawsuit, Bankers Trust was forced to turn over 6,500 tapes and 300,000 pages of written material. Holland, who broke the story about the tapes for Business Week, told FRONTLINE that employees were heard talking about derivatives as "a massive, huge future gravy train" and a "wet dream." In addition, there was talk about a "rip-off factor" and that Bankers Trust "set 'em [various clients] up." Bankers Trust denied that this talk was widespread and said that the parties involved were disciplined, but the then-legal adviser for Proctor & Gamble, Denis Forster, claims that "it was all those sound bites in the tapes that really grabbed the attention of the public, and also corporate America."
In 1996, Bankers Trust settled with Proctor & Gamble, forgiving most of the $200 billion P&G owed the bank. The Bankers Trust chief executive stepped down and the bank reduced its participation in derivatives. It was eventually sold to Deutsche Bank in 1998.