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Guest Post: Are Interest Rate Derivatives a Ticking Time Bomb?

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Washington’s Blog

Derivatives are the world’s largest market, dwarfing the size of the bond market and world’s real economy.

The derivatives market is currently at around $600 trillion or so (in gross notional value).

In contrast, the size of the worldwide bond market (total debt outstanding) as of 2009 was an estimated $82.2 trillion.

And the CIA Fact Book puts the world economy at $58.07 trillion in 2009 (at official exchange rates).

Interest rate derivatives, in turn, are by far the most popular type of derivative.

As Wikipedia notes:

The interest rate derivatives market is the largest derivatives market in the world. The Bank for International Settlements estimates that the notional amount outstanding in June 2009 were US$437 trillion for OTC interest rate contracts, and US$342 trillion for OTC interest rate swaps. According to the International Swaps and Derivatives Association, 80% of the world’s top 500 companies as of April 2003 used interest rate derivatives to control their cashflows.

So interest rate derivatives are the world’s largest market.

The largest interest rate derivatives sellers include Barclays, Deutsche Bank, Goldman and JP Morgan. While the CDS market is dominated by American banks, the interest rate derivatives market is more international.

In comparison to the almost $500 trillion in interest rate derivatives, BIS estimates that there were “only” $36 trillion in credit default swaps as of June 2009. Credit default swaps were largely responsible for bringing down Bear Stearns, AIG (and see this), WaMu and other mammoth corporations.

Where’s the Danger?

In 2003, John Hussman wrote:

What is not so obvious is the extent to which the U.S. economy and financial markets are betting on the continuation of unusually low short-term interest rates and a steep yield curve. This doesn’t necessarily resolve into immediate risks, but it could profoundly affect the path that the economy and financial markets take during the next few years, by making the unwinding of debt much more abrupt.
In response to very low short-term interest rates, many U.S. corporations have swapped their long-term (fixed interest rate) debt into short-term (floating interest rate) debt, to the extent that an increase in short-term rates could substantially raise default risks. Similarly, a growing proportion of homeowners have refinanced their mortgages into adjustable rate structures that are also sensitive to higher short-term yields. Finally, profitability in the banking system is unusually dependent on a steep yield curve, with a widening net interest margin (the difference between long-term rates banks charge borrowers and the lower short-term rates they pay depositors) …

***

According Bank for International Settlements, the U.S. interest rate swap market [has] nearly doubled in size in the past two years. The reason this figure is so enormous is that there are usually several links in the chain from borrower to investor. A risky borrower may enter a swap with bank A, which then takes an offsetting swap position with bank B (earning a bit of the credit spread as its compensation), and so on, with a cheerful money market investor at the end of the chain holding a safe, government backed security, oblivious to the chain of counterparty risk in between.

Aside from the risk that any particular link in this chain might be weak (know thy counterparty), the U.S. financial system has gone one step further. In order to hedge against the risk of defaults, banks frequently lay credit risk off by entering “credit default swaps” with other banks or insurance companies. These swaps essentially act as insurance policies for credit risk.

***

In short, the U.S. financial system is in a delicate balance. On the issuer side, a great many borrowers have linked their debt obligations to short-term interest rates. This is tolerated by the financial system because the debt has been swapped out through financial intermediaries, so investors get to hold relatively safe instruments like bank deposits and Fannie Mae securities. This mountain of debt in the U.S. financial system – tied to short-term interest rates – is ultimately and perhaps somewhat inadvertently backed by the U.S. government.

On the investor side, Asian governments intent on holding their currencies down relative to the U.S. dollar have purchased a great deal of U.S. government and agency debt – effectively “buying dollars.” … A reduction of demand for U.S. short-term debt, either by foreign governments (particularly in the event that Asian governments decide to revalue their currencies) or by U.S. investors, could have very undesirable consequences.

All of which is why the U.S. is now extremely dependent on short-term interest rates remaining low indefinitely.

In March 2009, Martin Weiss wrote:

Until the third quarter of last year, the banks’ losses in derivatives were almost entirely confined to credit default swaps — bets on failing companies and sinking investments.But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.

***

Thus, considering their far larger volume, any threat to interest rate derivatives could be far more serious than anything we’ve seen so far.

And Monday, Jerome Corsi argued that cities, states and universities might be wiped out by changes in interest rates:

As interest rates begin to rise worldwide, losses in derivatives may end up bankrupting a wide range of institutions, including municipalities, state governments, major insurance companies, top investment houses, commercial banks and universities.

Defaults now beginning to occur in a number of European cities prefigure what may end up being the largest financial bubble ever to burst – a bubble that today amounts to more than $600 trillion.

***

A popular form of derivative contracts was developed to permit one money manager to “swap” a stream of variable interest payments with another money manager for a stream of fixed interest payments.

The idea was to use derivative bets on interest rates to “hedge” or balance off the risks taken on interest-rate investments owned in the underlying portfolio.

If an institutional investment manager held $100 million in fixed-rate bonds, for example, to hedge the risk, should interest rates rise or fall in a manner different than projections, a purchase of a $100 million variable interest rate derivative could be constructed to cover the risk.

Whichever way interest rates went, one side to the swap might win and the other might lose.

The money manager losing the bet could expect to get paid on the derivative to compensate for some or all of the losses.

In the strong stock and mortgage markets experienced beginning in the historically low 1-percent interest rate environments of 2003 through 2004, the number of hedge funds soared, just as the volume of derivative contracts soared from a mere $300 trillion in 2005 to the more than $600 trillion today.

Unsophisticated Entities Getting Taken by Interest Rate Derivatives Salesmen

In 2008, Bloomberg pointed out that the SEC was investigating shady interest rate derivatives sales by JP Morgan and Morgan Stanley to school districts.

In 2009, New York Times writer Floyd Norris noted:

On the front page of The Times today, Don van Natta Jr. has a good article about the woes of little towns and counties in Tennessee that bought interest-rate derivatives sold by Morgan Keegan, an investment bank based in Memphis.

It turns out that these municipalities did not understand the risks they were taking. The derivatives have now blown up, and the officials are blaming the bank.

Matt Taibbi also recently noted that JP Morgan used interest rate swaps to decimate a small Alabama town:

The initial estimate for this project was $250 million. They ended up spending about $3 billion on this. And they ended up owing about $5 billion in the end, after you look at all the refinancing and the interest rate swaps and everything.

As the Bloomberg, Times and Taibbi stories hint, many unsophisticated schools, cities, states and universities were played by the big interest rate derivatives sellers, just as many people were played by the CDS sellers. So the fallout will likely be substantial.

Indeed, Larry Summers lost approximately $1 billion of Harvard University’s endowments using interest rate swap derivatives. Summers is the guy who is now running the U.S. economy.

But Aren’t Interest Rate Derivatives Straightforward and Useful?

You might assume that interest rate derivatives appear to have a much more straightforward, legitimate business purpose than credit default swaps.

Interest rate derivatives certainly help many individual businesses control and hedge their costs.  And they may be more straightforward and transparent than CDS.

But people tend to overestimate their ability to understand complex financial instruments. For example, the credit default swap salespeople and their bosses didn’t really didn’t understand CDS.

And – because the market for interest rate derivatives dwarfs the market for CDS – the reduced risks of each transaction might be collectively offset by the tremendous number of transactions and the gigantic size of the market as a whole.

In addition, when a bunch of individuals all attempt to reduce their risks at the same time in the same way, it can increase the risk to the overall system.

As George Soros pointed out in 1994, the excessive use of hedging can and often does backfire:

I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do they can be very disruptive, exactly because they affect the fundamentals of the economy…

The trouble with derivative instruments is that those who issue them usually protect themselves against losses by engaging in so-called delta, or dynamic, hedging. Dynamic hedging means, in effect, that if the market moves against the issuer, the issuer is forced to move in the same direction as the market, and thereby amplify the initial price disturbance. As long as price changes are continuous, no great harm is done, except perhaps to create higher volatility, which in turn increases the demand for derivatives instruments. But if there is an overwhelming amount of dynamic hedging done in the same direction, price movements may become discontinuous. This raises the specter of financial dislocation. Those who need to engage in dynamic hedging, but cannot execute their orders, may suffer catastrophic losses.

This is what happened in the stock market crash of 1987. The main culprit was the excessive use of portfolio insurance. Portfolio insurance was nothing but a method of dynamic hedging. The authorities have since introduced regulations, so-called ‘circuit breakers’, which render portfolio insurance impractical, but other instruments which rely on dynamic hedging have mushroomed. They play a much bigger role in the interest rate market than in the stock market, and it is the role in the interest rate market which has been most turbulent in recent weeks.

Dynamic hedging has the effect of transferring risk from customers to the market makers and when market makers all want to delta hedge in the same direction at the same time, there are no takers on the other side and the market breaks down.

The explosive growth in derivative instruments holds other dangers. There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated of investors. Some of these instruments appear to be specifically designed to enable institutional investors to take gambles which they would otherwise not be permitted to take ….

Doug Noland wrote an intriguing article in 2001 – based on the research of Bruce Jacobs (doctorate in finance from Wharton, co-founder of Jacobs and Levy Equity Management) on portfolio insurance – arguing that interest rate derivatives were widely being used without understanding the risks they create for the system (warning: this is long … go get some caffeine, sugar or exercise, and then come back and keep reading):

I would like to suggest moving Bruce Jacobs’ excellent book, Capital Ideas and Market Realities to the top of reading lists. From the forward by Nobel Laureate Harry M. Markowitz: “Many observers, including Dr., Jacobs and me, believe that the severity of the 1987 crash was due, in large part, to the use before and during the crash of an option replication strategy known as ‘portfolio insurance.’ In this book, Dr. Jacobs describes the procedures and rationale of portfolio insurance, its effect on the market, and whether it would have been desirable for the investor even if it had worked. He also discusses ‘sons of portfolio insurance,” and procedures with similar objectives and possibly similar effects on markets, in existence today.”From Dr. Jacobs’ introduction: “This book … examines how some investment strategies, especially those based on theories that ignore the human element, can self-destruct, taking markets down with them. Ironically, the greatest danger has often come from strategies that purport to reduce the risk of investing.

***

“In 1987, as in 1998, strategies supported by the best that finance theory had to offer were overwhelmed by the oldest of human instincts – survival. In 1929, in 1987, and in 1998, strategies that required mechanistic, forced selling of securities, regardless of market conditions, added to market turmoil and helped to turn market downturns into crashes. Ironically, in 1987 and 1998, those strategies had held out the promise of reducing the risk of investing. Instead, they ended up increasing risk for all investors.”

***

I would like to explore the concepts behind the current dangerous fad of derivatives as a mechanism to insure against rising interest rates, as well as the momentous ramifications to both financial market and economic stability from these instruments that rely on dynamic hedging strategies. From Jacobs: “Option replication requires trend-following behavior – selling as the market falls and buying as it rises. Thus, when substantial numbers of investors are replicating options, their trading alone can exaggerate market trends. Furthermore, the trading activity of option replicators can have insidious effects on other investors.”

Dr. Jacobs adeptly makes the important point that the availability of portfolio insurance during the mid-1980s played a significant role in fostering speculation that led to the stock market bubble and the crash that followed in October 1987. “Rather than retrenching and reducing their stock allocations, these investors had retained or even increased their equity exposures, placing even more upward pressure on stock prices. And, of course, as equity prices rose more, ‘insured’ portfolios bought more stock, causing prices to rise even higher…Ironically, the dynamic trading required by option replication had created the very conditions portfolio insurance had been designed to protect against – volatility and instability in underlying equity markets.And, tragically, portfolio insurance failed under these conditions (because…it was not true insurance). The volatility created by the strategy’s dynamic hedging spelled its end.”

***

“In the months following the (1987) crash, a number of investigative reports examined the trading data for the crash period. The Securities and Exchange Commission and the Brady Commission (the Presidential Task Force), for two, found that the evidence implicated portfolio insurance as a prime culprit.” …

Dr. Jacobs’ wonderful effort explains … the potential dangers of a complex financial theory taken up with little appreciation of its suitability for real-world conditions and applied mechanistically with little regard for its potential effects. It is a story about how a relatively small group of operators, in today’s complicated and interconnected marketplaces, can wreak havoc out of all proportion to their numbers…it is a story of unintended consequences. For synthetic portfolio insurance, although born from the tenets of market efficiency, affected markets in very inefficient, destabilizing ways. And option replication, although envisioned as a means for investors to transfer and thereby reduce unwanted risk, came to be a source of risk for all market participants.”

Unfortunately, this language seems at least as applicable to today’s interest rate derivative market as it was for equity portfolio insurance. It is certainly our view that the contemporary U.S. and global financial system characterized by unfettered money, credit and speculative excess creates unprecedented risk for all market participants, as well as citizens both at home and abroad. Not only have flawed theories prevailed and past crises been readily ignored, derivatives (interest rate in particular) have come to play a much greater role throughout the U.S. and global financial system. The proliferation of derivative trading is a key element fostering credit excess and a critical aspect of the monetary processes that fuel recurring boom and bust dynamics, as well as the general instability wrought by enormous financial sector leveraging and sophisticated speculative strategies. This certainly makes the proliferation of interest rate derivatives significantly more dangerous than stock market derivatives. Under these circumstances, it does seem rather curious that more don’t seriously question the soundness of this unrelenting derivative expansion. Unfortunately, ignoring the dysfunctional nature of the current system does not assist in its rectification – anything but. Indeed, it is my view that these previous market dislocations will prove but harbingers of a potentially much more problematic crisis that is quietly fermenting in the U.S. (global) credit system.

***

Clearly, the gigantic interest rate derivative market should be recognized as a very unusual beast. Instead of providing true interest rate hedging protection, this is clearly the financial sector having created a sophisticated mechanism that, despite its appearance, is limited to little more than “self insurance” – “The Son of Portfolio Insurance.” I have written repeatedly that markets cannot hedge themselves, and that derivative “insurance” is different in several critical respects from traditional insurance. From Dr. Jacobs: “Synthetic portfolio insurance differs from traditional insurance where numerous insured parties each pay an explicit, predetermined premium to an insurance company, which accepts the independent risks of such unforeseeable events as theft or fire. The traditional insurer pools the risks of many participants and is obligated, and in general able, to draw on these premiums and accumulated reserves, as necessary, to reimburse losses. Synthetic portfolio insurance also differs critically from real options, where the option seller, for a premium, takes on the risk of market moves.” Such exposure to unrelated events is far different from exposure to a market dislocation. Quoting leading proponents of portfolio insurance from 1985, “it doesn’t matter that formal insurance policies are not available. The mathematics of finance provide the answer…The bottom line is that financial catastrophes can be avoided at a relatively insignificant cost.”Amazingly, such thinking persists to this day. The above language, of course, is all too similar to the flawed analysis/erroneous propaganda that is the foundation for the proliferation of hedging strategies and the explosion of derivative positions. Dynamic hedging makes two quite bold assumptions that become even more audacious as derivative positions balloon: continuous markets and liquidity. As writers of technology puts …experienced, individual stocks often gap down significantly on earnings or other disappointing news, not affording the opportunity to short the underlying stock at levels necessary to successfully hedge exposure. And when the entire technology sector was in freefall, market illiquidity made it impossible for players to dynamically hedge the enormous amount of technology derivatives (put options) that had been written over the boom (especially during the final stage of gross speculation). The buying power necessary to absorb the massive shorting necessary for derivative players to offload exposure (through shorting stocks or futures) was nowhere to be found – so much for assumptions.

Granted, derivatives can be a very effective mechanism for individual participants to shift risk to others, but a proliferation of these strategies significantly influences their effectiveness and general impact. The availability of inexpensive “insurance” heightens the appetite for risk and exacerbates the boom. This characteristic has significant ramifications for both the financial system and real economy. It also creates completely unrealistic expectations for the amount of market risk that can be absorbed/shifted come the inevitable market downturn. Many adopt strategies to purchase insurance at the first signs of market stress. Once again, the market cannot hedge itself, and the tendency is for derivative markets operating in a speculative environment to transfer risk specifically to financial players with little capacity to provide protection in the event of severe financial market crisis.

***

There is another key factor that greatly accentuates today’s risk of a serous market dislocation, that was actually noted by the BIS: “Net repayments of US government debt have affected the liquidity of the US government bond market and the effectiveness of traditional hedging vehicles, such as cash market securities or government bond futures, encouraging market participants to switch to more effective hedging instruments, such as interest rate swaps.”

This is actually a very interesting statement from the BIS. First, it is an acknowledgement that “liquidity” and the “effectiveness of traditional hedging vehicles” have been impaired, concurrently with the exponential growth of outstanding derivative positions. This is not a healthy divergence. We have posited that the explosion in private sector debt, having been the leading factor fueling U.S. government surpluses, has produced The Great Distortion. As such, the viability of hedging strategies such as those that entailed massive Treasury securities sales in 1994 is today suspect. There are fewer Treasuries and a much less liquid Treasury market, in the face of unimaginable increases in risky private-sector securities and hedging vehicles. And while this momentous development has not yet created significant market disruption, the true test will come in an environment of generally increasing interest rates. Rising market rates will dictate hedging-related securities sales, and will test the liquidity assumptions that lie at the heart of derivative strategies. It is certainly my view that models that rely on historical relationships between public and private debt are increasingly inappropriate in today’s bubble environment, as are the associated assumptions of marketplace liquidity. Importantly, dynamically shorting securities in the liquid Treasuries market is no longer a viable method for the financial sector to hedge the enormous interest rate risk that they have created. The “answer” to this dilemma, apparently, has been an explosion of “more effective hedging instruments, such as interest rate swaps (from the BIS).” We very much question the use of the adjective “effective.” …

All the same, the interest rate swaps market remains Wall Street’s favorite “Son of Portfolio Insurance.” A similar pre-’87 Crash perception of a “free lunch” conveniently opens the door to playing aggressively in a speculative market. But an interest rate swap is only a contact to exchange a stream of cash flows, generally with one party agreeing to pay a fixed rate and the other party a floating rate (settling the difference with periodic cash payments). With characteristics of writing an option, the risk of loss is open ended for those taking the floating side of the swap trade. There’s no magic here, with one party a loser in this contract in the event of a significant jump in market rates. In such an event, this “loser” will certainly plan to dynamically hedge escalating exposure. If you are on the “winning” side, you had better accept the fact that the greater your “win,” the higher the probability of a counterparty default. Somewhere along the line, these hedging strategies must be capable of generating the necessary cash flow to pay on derivative “insurance” in the event of higher interest rates. Obviously, the highly leveraged and exposed financial institutions that comprise the swaps market have little capacity to provide true insurance. In a rising rate environment, these players will have enough problems of their own making as they are forced to deal with their own bloated balance sheets, mark-to-market losses [what a quaint notion], and other interest rate mismatches, let alone enormous off-balance sheet exposure. As I have written previously, purchasing large amounts of protection against sharply higher interest rates from the U.S. financial sector makes about as much sense as the failed strategy of contracting with Russian banks for protection against a collapse in the ruble. Sure, one can play this game, but we are all left to hope that the circumstances never develop where there is a need to collect on these policies.

***
At some point, higher interest rates will force the financial sector to short securities to dynamically hedge the massive interest rate exposure that has been created. What securities will be sold and from where will buyers be found with the necessary $100s ($ trillion plus?) of billions of liquidity? Will agency securities be aggressively shorted? What are the ramifications of such a development to a market that is almost certainly highly leveraged with enormous speculative trading? I can assure you that these are questions that the derivative players would rather not contemplate, let alone discuss. …The problem is that the strong perception that has developed that holds that the Fed will ensure that interest rates and liquidity conditions remain market friendly is actually the key assumption fostering the explosion in interest rate derivatives and reckless risk-taking. It should be clear that the assumptions of liquidity make no sense whatsoever without the unspoken assurances from the Federal Reserve. The resulting proliferation of derivatives, then, has played a momentous role in the intermediation process whereby endless risky loans are transformed into “safe” securities and “money.” The credit system’s newfound and virtually unlimited capability of fabricating “safe” securities and instruments is the mechanism providing unbounded availability of credit – the hallmark of “New Age Finance.” It is the unbounded availability of credit that, at this very late stage of the cycle, that creates extreme risk of dangerous financial and economic distortions, including the distinct possibility of heightened inflationary pressures. Ironically, the proliferation of interest rate derivatives has created the very conditions that they had been designed to protect against – volatility and instability in the underlying credit market, as well as acute vulnerability to the real economy.

***

The bad news is that there sure is a lot riding on what appears to be one massive and increasingly vulnerable speculation and derivative bubble that fuel the perpetuation of the historic U.S. Credit Bubble. I have said before that I see the current bets placed in the U.S. interest rate market as probably “history’s most crowded trade.”

Conclusion

Most economists and financial institutions assume that interest rate derivatives help to stabilize the economy.

But cumulatively, they can actually increase risky behavior, just as portfolio insurance previously did. As Nassim Taleb has shown, behavior which appears to decrease risk can actually mask long-term risks and lead to huge blow ups.

Moreover, there is a real danger of too many people using the same strategy at once. As economist Blake LeBaron discovered last year, when everyone is on the same side of a trade, it will likely lead to a crash:

During the run-up to a crash, population diversity falls. Agents begin using very similar trading strategies as their common good performance is reinforced. This makes the population very brittle…

Given that the market for interest rate derivatives is orders of magnitude larger than credit default swap market – let alone portfolio insurance – the risks of a “black swan” event based on interest rate derivatives should be taken seriously.

Anything that is orders of magnitude larger than the global economy could be risky – one unforeseen event and things could destabilize very quickly.  Too much of anything can be dangerous. Water is essential for life … but too much and you drown.

But I am confident that no one – even the people that design, sell or write about the various interest rate derivatives – really know how much of a danger they do or don’t pose to the overall economy.   In addition to all of the other complexities of the instruments, the very size of the market is unprecedented.  Independent risk analysts would do a great service if they quantified and modeled the risk.

Finally, even if the widespread use of interest rate derivatives does not harm the economy as a whole, it will certainly harm the cities, states and other governmental and quasi-governmental entities which are on the wrong side of the trade. My hunch is that – just as the fraud in the CDO and CDS markets was exposed when the “water level” of the economy fell, exposing the rocks underneath – rising interest rates will reveal massive fraud in the interest rate derivative market.

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39 comments

  1. Doc Holiday

    Derivatives defy Moore’s Law, they defy all laws and they are unregulated chaotic illusions that are the glue that are holding together the Depends that all the wall street bankers wear …

    let’s face facts kids, illegal drug trades on the black market (narcotics, meth and all that shit) amount to about a few hundred billion, or less than Warren B spends on cookies in a year; that sum is about 1% of world GDP, which in 2003, was measured at $36 Trillion — hence, to put some perspective into drug-dealer-like derivative trade, which essentially is the exchange of addictive and destructive synthetic substances …. hmmm, where was I ….. oh yes, back to this story and this tidbit:

    The derivatives market is currently at around $600 trillion or so (in nominal value).

    >> Come on, let’s once again face facts, every politician, cop, lawyer and official involved in regulating this shit can be paid multi, multi, multi-millions of bucks to look the other way — and thus, there will never be regulation in this market, because it is too big to be real, too big to be pondered, too big to be dreamed — this market is beyond comprehension, which is why I’m here to help and go back to Moore’s Law, which of course suggests that computing processing power will double about every 18 months — which is really nice, but as we all know, keeping up with technology is challenging more and more so, because computers are doing more and more and we understand less and less. To get back to derivatives, it’s amazing that the derivatives market is leaping ahead in quantum steps, steps that put Moore’s Law to shame — Moore’s Law has the equivalent speed of an ant walking down a freeway, while the derivative drug dealers are landing jets at transonic speeds… and then going faster and faster…. not good!

    Sorry, needed to vent:

    See: http://en.wikipedia.org/wiki/Prandtl–Glauert_singularity

  2. FGR

    one should look at NET exposures and not GROSS exposures, as the most important source of risk. GROSS exposure is not to be neglected, but looking at NET exposures, the IR market is much smaller than it seems. also short ends are in the control of Central Banks, the market is manipulated. high volatility in this part is really a black swan. also short term derivatives notionals are boosted by the fact that DV01s ($ risk value per notional) is much less than longer maturities. thats boosting the gross figure as well.
    there is no reason to think that overall the growth of the derivatives is outpacing the growth of the underlying debt, which is the real problem. there are speculators placing bets of course, but it cant be more than the depth of the market, which is limited by the capital of the speculators vs capital of market-makers.

    i think worrying about the underlying debt problems is enough of a headache, and should be given the priority.

    not to say there arent problems (in fact i see many… !) but derivatives in itself is not the cause of the debt bubble, which is the real #1 problem

      1. alpha_bet

        Yes, they are simply to exchange a fixed rate obligation for a floating rate or vice versa.

          1. alpha_bet

            You asked what the legitimate business reason was. It is to more easily control rate risk and cashflows.

          2. DR

            a $600 Trillion instrument to finance the hedging needs of business sounds a little far fetched.

  3. Daniel de Paris

    derivatives in itself is not the cause of the debt bubble, which is the real #1 problem

    Derivatives were certainly part of the problem. One should be honest and admit that they essentially allowed the credit levels to grow of control.

    Of course, noone would have lent that much without these “creative” instruments. It is so obvious that noone seems to catch it. Is there any chance that someone can get something that may signal the end of your profession? Of course not.

    1. mannfm11

      These swaps along with the carry trade allowed for a lot of laying off of risk. Of course the bankers knew more than the unsuspecting customers to whom they peddled these instruments. If you read Minsky, you find that the structure of rates we have at this time is prime territory for blowing bubbles and creating the next crisis. When this mess peaks, the nuts and bolts that are holding it together are going to strip out. I don’t fully understand interest rate swaps, except to say that there is a difference between the costs of one party paying the other the return on a 10 year versus a short term and I suspect that the swap rate is the difference of the sum of the two. I don’t know if both rates move or not as the time moves forward, but it is clear the short term rate moves. It appears the banks bet on short term rates to fall, as they knew the Federal Rook system would bail them out at the expense of their customers. So, one party pays the 10 year rate, the other party now pays next to zero. Which side are the bankers on?

  4. Wanderer

    Agree with FGR, interest rate derivatives have much less risk than credit default swaps.

    First, unlike CDS, you can’t lose 100% of the ‘notional’. Second, prcicing is much simpler and can be executed with observed value.

    Lastly, you can hedge away much of the risk on an interest rate swap with euro$ futures and note futures. No such hedge mechanism exists for CDS

    1. Yearning to Learn

      First, unlike CDS, you can’t lose 100% of the ‘notional’. Second, prcicing is much simpler and can be executed with observed value

      I’m not necessarily sure that your explanation proves that IRS are “less dangerous”

      1) although you can’t lose 100% of notional value, the notional value is so large that even small losses will cause huge losses in dollar terms. (a 1% loss of $600T is $6T).

      2) pricing may be simpler, but so are the players. As we’re seeing, it’s not the so-called “sophisticated investors” buying these things. It’s schoolboards in backwater areas.

      I agree with you that $100M of CDS are more dangerous than $100M of IRS, I’m just not sure that (rounded) $40T of CDS are more dangerous than $550T notional of IRS

        1. Poco Ritard

          A backwoods school board is going to trust the nice man in an from New York in an expensive suit who says not to worry, he’s going to take care of them.

  5. charles

    If it is dynamic hedging that worries you the most, swaps and forwards are irrelevant, because they don’t generate dynamic hedging (hedge is static at the beginning of the transaction). As far as options are concerned, it is the net notionals of sold and bought options which are important.
    According to the same BIS statistic http://www.bis.org/statistics/otcder/dt08.pdf , what we have is 520 billion for maturities lower than 1 Y, 800 for 1-5Y and minus 320 above 5Y. This is one order of magnitude less than mortgage outstanding (14 trillion for the US alone http://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm ). Most of these mortgages embed an interest rate option (“somebody” has to bear the burden of the “rate-down-I-refinance-rate-up-I-stay-put” option !).
    Conclusion :
    As far as interest rate options are concerned, the cash market is the dog, and the derivative market is the tail, not the other way round.

  6. Thomasina Jefferson

    Derivatives were very much at the heart of this problem. Their use is what allowed this to happen in the first place. All these bad loans could not have been distributed around the world without these derivatives.
    Without derivatives, these bad loans would have remained on the books of the issuer – and he would have been the only one to fold.
    Derivatives only serve two purposes: to conceal the reality and to generate fees. They are ideal to hide fraud and do enable moral hazard to occur.

  7. Anon48

    I think you’re taking your eye off the ball. IRS’s aren’t nearly as risky a CDS’s.

    Assume our company borrows money under a variable rate loan agreement and then later enters into a separate swap agreement to exchange our variable rate stream of payments for a fixed rate stream of payments.

    A year later our risk on the swap is limited to the spread between the fixed rate that we purchased from the swap counterparty and the current interest rate that we’d be charged on our original loan (which is based upon the particular index imbedded in the loan agreement) if the counterparty failed to perform. (e.g if our current variable rate is 7% and the fixed rate protection we purchased was 5.5%, then our current risk is equal to the spread between the two- only 1.5%).

    Should counterparty failure occur we would only have to come up with 1/12th of the extra spread each month. Annoying – most definitely, painful- possibly, if market rates had increased significantly, catastrophic- probably not. CDS risk from counterparty failure, on the other hand, could involve up to 100% of the value of the asset that you’re trying to protect.

    1. Adam

      Anon48,

      I can’t say that I understand derivitives, but I think you’re missing the point. Even if IRS are a tiny fraction of the risk of a CDS, the size of the market is many many magnitudes larger. That means the amount of liquidy required to counter the risk is not small. This is the problem. If you add up a lot of small risks all at once the demands for liquidity could surpass the markets ability to supply it forcing a market failure – that’s the black swan event that’s being warned about.

      1. alpha_bet

        You do not understand derivatives. The notional size of the IRS is very close to irrelevant. The notional will never exchange hands, it is only used to calculate what the payments will be, which are a very small fraction of the notional.

      2. AndyC

        This notional value argument seems bogus

        IRS are many times highly leveraged bets on interest rate moves?

        What difference does it make if they pay the entire notional value.

  8. Tim

    Latest quarterly report:
    http://www.occ.treas.gov/deriv/deriv.htm

    The notional value of derivatives held by U.S. commercial banks increased $8.5 trillion in the fourth
    quarter, or 4.2%, to $212.8 trillion…

    Five large commercial banks represent 97% of the
    total banking industry notional amounts and 88% of industry net current credit exposure…

    From year-
    end 2003 to 2008, credit derivative contracts grew at a 100% compounded annual growth rate.

    1. jpe

      It didn’t “blow up;” they opted for a fixed rate on their loans and then interest rates went down. There’s nothing about the interest rate swap that wouldn’t apply as equally to regular bond financing.

  9. ella

    Case on point.

    http://www.bloomberg.com/apps/news?pid=20601109&sid=admhxP5DjTPE&pos=15

    This is what happened to small town in the Seattle metro area. In order to save $2.9 million, they entered into an interest-rate swap. In order to get out of the contract that blew up, the water and electric customers will pay an additional $14 million to get out of an agreement with American International Group Inc.

    Think about that.

    14 million to save 2.9 million. Did the utility district that entered into this contract ever suspect the true cost of the contract? What did the issuer of the contract do to earn 14 million? Should such contracts be void as a matter of public policy? Should the utility district that entered into the contract be personally liable instead of the consumer? How much will the increase in water and electric rates cost the consumer? How will that effect their savings, discretionary income and the local economy?

  10. Independent Accountant

    I never thought derivatives stabilize the economy. If anything, they encourage riskier behavior and destabilize the economy. Remember “portfolio insurance” which didn’t prevent the 1987 stock market crash?

    1. Thomasina Jefferson

      Agree with you. All they do is to redistribute the risks in your books to someone else’s books. That’s then called risk management. If enough people do this, risk will not diminish but increase for everyone.

      1. Yearning to Learn

        they are doing worse than simply redistributing the risk, that is the essence of this article.

        They are redistributing and also increasing volatility, making the risk of up and downside even worse.

        the icing on the cake is that they create numbers so large that they dwarf the entire world economy.

        How many derivatives by notional value can world GDP support?
        $100T
        $1,000T
        $1,000,000T

        because there is little to nothing that prevents this exponential growth, except for a financial crises… which seems to have slown the growth for what… 18 months?

  11. sunny129

    The great fallacy of RISK mitigation apparently gave birth to Derivative. Now we all know that it was NOT an angel to save you but a Frankenstein raised, fed and sold in dark by Banksters! Now that ‘Karma’ marching back towards the masters!

    There is NO free lunch!

    1. Anonymous Jones

      What exactly does “no free lunch” mean? Should we go back to an economy where everyone produces their own food and clothing? Do specialization, trading and barter have no ability to expand the resources for all? Is it really not possible that interest rate swaps could allocate interest rate and cash flow risk to those in better positions to handle it (those with different preferences for cash flow, different ages, different time horizons and different consumption preferences)? I’m confused, as so often happens…

      By the way, CDS are toxic and in no way comparable to IRS.

      1. ron

        “Is it really not possible that interest rate swaps could allocate interest rate and cash flow risk to those in better positions to handle it (those with different preferences for cash flow, different ages, different time horizons and different consumption preferences)?”

        This Neo-liberal theory is what has now been applied to the greater financial system as a whole including fractional-reserve banking (Derivatives can actually increase leverage beyond conventional fractional reserve lending). The financial sector has invariably shown their penchant for speculative investment and the encouragement of asset bubble formation rather than productive investment through-out history.
        Why? In the short-run speculative investment is much more profitable for the financial sector,as a mania boils in a particular asset class the cost for funding such speculation decreases below the cost of funding productive investment. So it actually becomes less expensive to fund Asset price speculation at a certain point and this is what discourages investment into sustainable income-earning value producing assets.

        All Asset speculation does is absorb capital which otherwise would have been allocated to investment in income earning (from labuored) activities.

  12. FGR

    derivatives range from the simplest products to the more complex. IMHO the more complex ones are designed to conceal revenues, evade regulations, evade taxes, generate fees. its really a horrible business with no social purpose.

    HOWEVER, i still maintain debt levels are the #1 problem. derivatives (CDOs etc…) were necessary to sell risky debt as non-risky to investors, but that is only the symptom… the problem is too many bad borrowers piled on debt, and careless investors bought it. derivatives is a part of the debt bubble.

    we could have had a debt bubble without derivatives. now if one stop derivatives trading at once, the debt market is dead: a lot of demand for debt was there because of derivatives. the borrowers still need to issue more debt but the buyers are not, and wont be there if you stop everything at once.

    now its ridiculous to think derivatives mkt outgrew the debt mkt. people sold derivatives to package debt. derivatives growth was in line with the underlying. maybe gross notionals grew faster, but NET notionals were surely in line. im ready to bet on it.

    thus in the end, the problem lies in the fact that the system needed more and more debt to function.. which is unsustainable.

    derivatives is just a small part of the story. we would have had the same outcome without derivatives.

    1. Yearning to Learn

      FGR:
      you may be right, but how to know. To me this is a chicken and egg problem.

      You seem to think that the debt is the bigger problem, and derivatives just a system.

      perhaps.

      some of us are arguing that the debt COULDN’T have gotten to be such a big problem without the derivatives. Thus, the derivatives increase the debt problem

      it’s like an addict.

      Imagine a world with only marijuana. The pot-addicted addict can self-implode but doesn’t in general cause much collateral damage.

      Now imagine adding crystal meth. Crystal meth addicts are far more dangerous to the community at large.

      is the “bigger” problem the addict, or the crystal meth supply?

      in the same way we have debt addicts. Supplying them with derivatives makes the problem far more explosive. eliminating them does not eliminate the debt addict… but it does reduce their danger to society.

      1. E.b. White

        I cannot do the book justice, but it can be read in two hours, can be applied immediately, and will pay dividends in perpetuity. Good investment.

  13. Eric L. Prentis

    OTC Derivates Market is justified by, “it doesn’t matter that formal insurance policies are not available. The mathematics of finance provide the answer…The bottom line is that financial catastrophes can be avoided at a relatively insignificant cost.” What if the mathematics of finance, which assume the Efficient Market Theory (EMT), ARE WRONG?
    The EMT defines markets as:
    1) being in equilibrium and if unexpected events cause disequilibrium, it is only temporary, that is, markets are self-equilibrating;
    2) asset prices “fully reflect” all available information, properly represent each asset’s intrinsic value, and as a result, prices are always accurate signals for capital allocation;
    3) stock prices move randomly or are uncorrelated with, if not entirely independent of, the prior period’s price change, consequently, beating the stock market on a risk-adjusted basis should be impossible to achieve when solely using technical analysis mathematical models or stock charts to make trading decisions.
    Dr. Eugene Fama’s Famous 45 Year Old Challenge Solved

    Fama’s (1965, 1995, Financial Analysts Journal) 45 year old challenge for technical analysis is to “rigorously test mechanical trading rules to show they can consistently make better than chance predictions of stock prices.”

    Technical analysis mechanical trading rules for an S&P 500 Index portfolio substantially beat a naïve buy-and-hold policy—by two-and-a-half times—at just two-thirds the risk. For 81 years, the stock market has not been efficient, the data do not support the EMT, consequently, the OTC Derivatives Market does not have an intellectual leg to stand on!!! Obviously, getting academe to accept this fact is a long and slow process. I desperately need all the help I can get, please read the empirical research paper below.
    http://www.theastuteinvestor.citymax.com/f/Do_Inv_Emot_Create_Ineff_Mkts.pdf

  14. DR

    A swing of 1% in interest rate on a notional value of $500 trillion is $5 trillion. Does anybody really think that counter parties can hedge this amount?

    1. mannfm11

      It appears to be greater than that, but then again I don’t know the exact formula and how it is marked over time. I have the formula on my desktop, but is the instrument stable or do both rates move with time? Thus, do the holder of the 10 year rate get the 10 year rate a year from now in return for the short term rate or is the short term guy assuming all the risk? Thus, I agree to pay 3.8% or whatever the 10 year rate is and the other agree to pay what comes up? I do know from the formula that the shorter term rate can be hedged with zero coupon bonds and that is how the rate is derived on a daily basis. But, if there is a 1% differential, it is 1% a year if the perception is 1% a year, not 1% total. Thus $600 trillion would move $6 trillion a year, not $6 trillion total. The Fed has little control of rates beyond the overnight rate and the Fed itself is carrying a lot of rate risk. I wonder if the Fed is hedging its bets?

  15. Jimbo

    Don’t forget Summer’s failed attempt at predicting interest rates at Harvard…..
    Harvard Swaps Are So Toxic Even Summers Won’t Explain (Update3)
    ………
    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aJnjG1iQHZK0…………………..

    Dec. 18 (Bloomberg) — Anne Phillips Ogilby, a bond attorney at one of Boston’s oldest law firms, on Oct. 31 last year relayed an urgent message from Harvard University, her client and alma mater, to the head of a Massachusetts state agency that sells bonds. The oldest and richest academic institution in America needed help getting a loan right away.

    As vanishing credit spurred the government-led rescue of dozens of financial institutions, Harvard was so strapped for cash that it asked Massachusetts for fast-track approval to borrow $2.5 billion. Almost $500 million was used within days to exit agreements known as interest-rate swaps that Harvard had entered to finance expansion in Allston, across the Charles River from its main campus in Cambridge, Massachusetts.

    The swaps, which assumed that interest rates would rise, proved so toxic that the 373-year-old institution agreed to pay banks a total of almost $1 billion to terminate them. Most of the wrong-way bets were made in 2004, when Lawrence Summers, now President Barack Obama’s economic adviser, led the university. Cranes were recently removed from the construction site of a $1 billion science center that was to be the expansion’s centerpiece, a reminder of Summers’s ambition. The school said last week they will suspend work on the building early next year.

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