Interest Rate Swaps and Other Likely Problems August 13, 1999

The bulls had their way with us bears this week, as the Dow gained 260 points, or 2-=%. The S&P 500 and Morgan Stanley Cyclical indices gained 2%, as did the small cap Russell 2000. The Morgan Stanley Consumer index underperformed, rising just 1%, while the Transports dropped 1% and the interest-rate sensitive Utilities were hit for 2%. It was a buying stampede throughout the technology and financial sectors. The NASDAQ 100 gained 4%, increasing its year-to-date gain to 26%. The Morgan Stanley High Tech index and the semiconductors both rose 5%, bringing their 1999 gains to 33% and 48%. The Internets also rallied strongly late this week, with The Street.com Internet index gaining 6%. Despite all the talk of the big Internet sell-off, the Street.com Internet index sports a 30% gain for the year. The financials also had a powerful rally with the S&P Bank index gaining 4% and the Bloomberg Wall Street index surging 7%. At least for a few days, the market was able to ignore the darkening storm clouds encircling our financial system.

As we have written previously, US banks currently have off-balance sheet derivative obligations in excess of $33 trillion. Of this, fully $25 trillion are interest rate-related instruments. The growth of these products has been truly astounding. From less than $4 trillion at the end of 1991, interest rate derivatives swelled to $9.9 trillion by the end of 1994. Many of these derivatives proved quite problematic for many, and disastrous for some, in 1994 when the Federal Reserve began tightening policy after a long period of extraordinary low interest rate accommodation. There were heavy losses and even bankruptcies in the hedge fund community, some big losses and lawsuits from corporations stung by derivatives, and the Mexican financial meltdown. And who can forget the sad situation where leveraged positions in structured notes issued by Fannie Mae, Freddie Mac and Sallie Mae led to the bankruptcy of Orange County. Yet, none of this seemed to dampen the enthusiasm for derivatives. Although total interest rate derivative growth did slow to $1.1 trillion in 1995, derivatives were right back in vogue in 1996 with $2.3 trillion additional interest rate derivatives created. Growth further accelerated in 1997 with an additional $3.7 trillion. Nothing, however, compares to last years derivatives explosion, especially in the interest rate area. Indeed, interest rate derivative positions expanded by an amazing $7.7 trillion, more than the total interest rate derivatives outstanding at the end of 1993.

Inarguably, the system went absolutely nuts beginning last summer. During the second half of last year, in the midst of a heightened global crisis, the collapse of Long Term Capital Management, and a near financial debacle, total derivative positions grew almost $5 trillion. And it was certainly not a coincidence that this happened concurrently with the greatest explosion of credit growth in history. In particular, there was an unprecedented expansion of financial credit as many major financial institutions, including Fannie Mae and Freddie Mac, aggressively borrowed in the money markets or used other short-term financing vehicles to leverage mortgages and other financial assets. Digging further in to the details, we see that interest rate swaps increased $3.5 trillion during last years second half, an annualized growth rate of 65%. Total interest rate swaps ended the first quarter at $14.6 trillion, and it is precisely here that we see what we believe is at the heart of todays problem: A major dislocation in the interest-rate-hedging arena. As history has proven time and again, all one needs to do to spot an upcoming financial problem is to recognize the area that has been most prone to egregious credit and other excesses. In this regard, we have a keen eye on interest rate swaps.

First, lets look at the definition of an Interest Rate Swap  "a contract in which two counter-parties agree to exchange interest payments of differing character based on an underlying notional principal amount that is never exchanged." Basically, a swap just allows the exchange of interest rate risk from one party to another. While there are many variations of swaps, their recent spectacular growth is certainly associated with the proliferation of leveraged speculation that has become endemic to our financial system. Whether it has been the over-enterprising hedge funds and securities firms that leverage mortgages, asset-backs, junk bonds and agency securities in the repo (repurchase) market, or Fannie and Freddie that aggressively use money market borrowings to finance their bloated balance sheets of mortgages, or companies such as GE Capital and GMAC that borrow in the money markets to finance holdings of various loans and receivables, these strategies of borrowing short and lending long create significant interest rate risk. And in this vein, remember that our financial sector increased borrowings last year by more than $1 trillion, in what largely amounted to one massive interest rate arbitrage.

Many speculators incorporated the use of swaps and other interest rate derivative products, thus basically shifting some of their interest rate risk to the writers of these swaps and helping mitigate interest rate exposure. The writers of these swaps were more than happy to book the premium charged for these products right to the bottom line, expecting that they would hedge their risk if rates began to rise. A particular type of instrument became very popular, a so-called swaption. "A swaption is a contract on an interest rate swap. The contract gives the buyer the option to execute an interest rate swap on a future date, thereby locking in the financing cost at a specified fixed rate of interest. The seller of the swaption, usually a commercial bank or investment bank, assumes the risk of interest rate changes, in exchange for payment of a swap premium."

Valuing these types of swaps with embedded options can be very tricky and writing such exceedingly volatile derivatives is a most risky endeavor, as many have learned this year. Another risky instrument that has become quite commonplace is the inverse floater. An Inverse Floater is often a mortgage-backed bond, usually part of a collateralized mortgage obligation bearing an interest rate that declines as an index rate, for example, the LIBOR rate, increases. The agencies have made these quite attractive, particularly to the speculators, with enticing, above-market yields. However, with interest rates rising and spreads widening sharply, there have been significant losses suffered in this area. Remembering how many of these types of instruments blew-up in 1994, we wonder when we will again hear the term "toxic waste". Putting all of these derivatives and instruments together, there should be little mystery as to why our credit market has become so unstable.

Today, the key point to recognize is that with interest rates moving sharply higher after a period of unprecedented credit excesses, leveraging, speculation and financial engineering, the massive, virtually systemic, interest rate arbitrage has faltered badly. Huge losses have been suffered and our acutely vulnerable credit system is today impaired. Now it will just be a matter of time until we find out how these losses will be shared among investors, financial institutions, the leveraged speculating community and their insurers, the derivative players. Actually, however, we do tend to lump the derivative players in with the leveraged speculating community. All the same, we just cant shake our nervousness when we compare todays $25 trillion of notional interest rate derivatives to the $7 trillion that existed at the end of 1993. After all, there were certainly enough derivative-related fiascoes in 1994 with $7 trillion outstanding. Here, the old mountain versus a mole hill adage seems appropriate. Also, keep in mind that to this point the Fed has only raised rates 25 basis points, so we could potentially be very early in this process. Today, there is simply so much uncertainty weighing on the credit markets as to the health of the key derivative players as well as general confusion as to how this will all work. With $100 trillion of derivatives globally, we are much in uncharted territory that is reflected in heightened risk premiums.

In this context, today there is absolutely no transparency to judge how some of these major players are weathering the storm. Combined, Fannie and Freddie have $500 billion in derivatives, but one can discern little from their financial statements in determining if they are indeed adequately hedged. They could be in fine shape or in big big trouble, but there is simply no way to know. Looking at Chase Manhattan, with the largest notional derivative exposure of any institution, they had $10.4 trillion of total derivative positions at the end of the first quarter, including $5.4 trillion of swaps and $3 trillion of forward contracts. Is their book properly hedged or is their derivative portfolio an accident waiting to happen? Again, there is absolutely no way to know. All the same, there is no doubt that many players in the marketplace have suffered great losses and this has led to a general dislocation in the swaps area with players left pondering the soundness of the entire market. Yesterday, 10-year swap spreads increased to as wide as 112, the highest since 1987. For comparison, this spread had not traded above 100 this decade, even during last falls near financial debacle. This spread began June at 79 and was 71 at the beginning of May. Additionally, the key TED spread, or the interest rate differential between Treasury and Eurodollar yields, widened almost 8 basis points yesterday, a quite notable one-day move. Even today, with a bond market rally and major stock market advance, the TED narrowed just 1 basis point to 85. The TED began June at 52.

But we will be the first to admit that all this seems rather moot on a day where the Dow gained 184 points and the S&P Bank and NASDAQ100 indices advanced 4%. And while the bulls and the pundits will celebrate todays benign inflation report, it is largely irrelevant to the big picture. The bottom line remains that we are in the midst of unfolding financial turmoil with a dislocation in the credit markets. We believe that the credit environment has changed and that we are in the process of witnessing a dramatic slowdown in the great Wall Street money spigot that has provided a virtual unlimited supply of easy credit for any borrower. Moreover, our economy is an over-heated bubble economy and, combined with our vulnerable financial system, is leading to the reevaluation of the long-term health of the dollar. And each month the bubble lingers only leads to more problematic distortions.

Yet, with one week to go until option expiration, todays news provided a fantastic opportunity to run the market. Certainly, derivatives played a key role in todays buying melee. However, one of these days derivatives will not be so helpful and, in fact, we fully expect that they will play a major role in a selling stampede. For now, however, and as we stated in a recent commentary, the bull has only been wounded and maintains quite a proclivity for particularly unruly and violent market action - the type of wild volatility that often proves a harbinger of a change in trend. In this regard, this is all rather "textbook" but that doesnt make it any easier to play. With todays announcement, the bulls took full advantage and gapped stocks open and forced the bears and derivative players to rush to unwind positions. With five days to go, a rally like todays does wonders for the writers of put options that would have been on the hook without a rally. They certainly won the battle for the day, and the week for that matter. But, over the coming week and months, it will be fundamentals that dictate who will be the big winners. With this in mind, we will not let todays market be too discouraging. http://www.prudentbear.com/markcomm/markcomm.htm .......................................................................Remember this:Amateurs built the Arch.Professionals built the Titanic

-- Drken (Drken@bubble.gone), August 15, 1999

Answers

Among the problems with derivatives it that of describing the magnitude of any subset of them. For example, in this article is the statement: "As we have written previously, US banks currently have off-balance sheet derivative obligations in excess of $33 trillion."

However, the $33 trillion is what is called the "notional amount". This "notional amount" is mentioned further on in this article, e.g. "First, let's look at the definition of an Interest Rate Swap "a contract in which two counter-parties agree to exchange interest payments of differing character based on an underlying notional principal amount that is never exchanged.""

What is actually being exchanged is the difference between two interest rates. The "principal" is never exchanged, and is never at risk. But it is that "principal" that is the "notional amount" that is reported as part of that $33 trillion, at least for the interest rate swaps portion thereof.

Describing the magnitude of derivative obligations is just one problem that one encounters when trying to appraise potential problems that may occur when deriviative postions become precipitously unsustainable, which some of them do from time to time. On some such occasions we read about, for example, an Orange County, California, default, or a Barings Bank default, or a LTCM bail out.

Someday, we may be reading about a bank x and bank y and bank z default, all in a short stretch of time.

Jerry

-- Jerry B (skeptic76@erols.com), August 15, 1999.

Hey Jerry,

It's called cascading cross-defaults and it's gonna happen...

flierdude is convinced that TPTB will do anything to prop the system up until rollover and then when it collapses blame it on y2k...

any way you cut it the system is TOAST...

I'm still not sure about options or shorting the dow... don't see how I can collect, the game is obviously rigged...

-- Andy (2000EOD@prodigy.net), August 15, 1999.

Andy,

I'm not convinced that they are trying to keep it going until January but I think it is highly probable. If they do keep it going, it will cost me my bet of around $11,000.00 that I have in Dow Puts. If they don't I tack another couple hundred K to my net worth.

-- flierdude (mkessler0101@sprynet.com), August 16, 1999.