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Wall Street Trumps Main Street: Asymmetric Info in Derivatives

06/14/2010 01:52 pm ET | Updated May 25, 2011

There has been a vigorous debate on the portions of Financial Regulation concerning Derivatives. This article by Jane D'Arista highlights why Derivative reform is an essential part of reducing systemic risk and bailout risk. However, financial reform is not only about reducing these risks. It is also about restoring balance, fairness and integrity to financial services, moderating corporate power and regulatory capture in Washington, and allocating resources in the economy in a way that provides more for job creating industries and less for the outsized financial sector. To take one quote from the article which addresses my focus today:

Buying and selling OTC derivatives contracts is a zero sum game. Unlike portfolio lending that links the fortunes of borrowers and lenders, one party to a derivatives transaction wins while the counterparty loses.

So let me pull back the curtain on how derivatives work in one particular area on Main Street. What is generally considered to be the most plain vanilla derivative product is the Interest Rate Swap. In simplified terms, what an Interest Rate Swap does is allow one party (generally a borrower of funds) to pay interest to a bank at a variable rate but to "synthetically fix" the rate through a swap. Another party takes the other side of the trade. The borrower will generally assume that party is the bank, but if the bank wanted to take and be paid for at the rate risk, it could just have made a fixed rate loan in the first place at a higher interest rate. There is another party (counterparty) that takes the interest rate risk in return for being paid a monthly payment.

So as a simple example, the borrower may have a $3 million loan. It might pay 3.5% per annum in variable rate interest to the bank. It may pay a payment equal to another 2.5% on the interest rate swap for an "all in" rate of 5.5%. The Counter Party gets the 2.5% (less than the market maker's fee), in order to assume the risk that rates will rise. The borrower is supposedly protected from a rise in interest rates.

On the surface, this seems pretty simple and a borrower might feel well prepared to make a good decision on the transaction.

Here are the problems as I see them:

  • The borrower has no way to know if the rate swap is a good deal. They buy something that seems simple but is in fact quite complex. Look at it this way, the borrower paid 5.5% instead of 3.5%. That is a 57% increase in the cost of credit. The borrower has paid a large sum of money and has few ways to ascertain if it is a good deal. You can rest assured that the counter party on the swap is much more sophisticated regarding the mathematics behind the transaction.They are financiers deliberately taking interest rate risk for a fee.
  • The bank may have limited the borrower's pricing options in order to induce him or her to enter into the interest rate swap. The bank could have offered a fixed rate loan. Banks do this all the time, except when they don't. Often a bank will not offer a fixed rate loan at all and will present the swap as the only way for the borrower to hedge interest rate risk.
  • The borrower may not have any other place to go to get the interest rate swap. Generally the swap is cross collateralized with the actual loan. Unless the borrower is shopping the loan and the swap at the same time, they have no competitive information available. Since 90% of swaps are done by 5 banks, if the borrower is shopping a big bank against a local or regional bank, the best swap pricing is not going to be available to the smaller bank anyway. So the big bank has a competitive advantage.
  • Swaps have risks to the borrower that are not necessarily apparent and may not be properly disclosed when the swap is sold. These include the very real chance that the swap can actually be "underwater" if terminated early. The amount it is "underwater" is based on complex mathematical formulas involving changes in interest rate curves from the time the swap was initiated until terminated. Further, the rate that is "hedged" is the "index" rate, not necessarily the borrower's loan rate.
  • The economic value of either side of a swap's position is a function of several factors, including the rate curve and discount rates. It is not a function of the index rate. The borrower will often not understand this. Effectively this means that the net position on the swap may not be correlated well with changes in the "index". It is somewhat analogous to the problems with pricing on some ETFs that are based on futures contracts. The ETF is intended to track a certain commodity price but since it actually owns futures contracts rather than the commodity itself, the value of the ETF does not correlate well with the intended benchmark.
  • The borrower's loan can be declared in default for a variety of reasons, including failing to maintain certain financial ratios, credit ratings, etc., even if there is no payment default. A loan default will generally trigger a default on the swap, which may become due and payable in full. The borrower may find that in addition to whatever other difficulties it is encountering, now a large unexpected payment is due on the swap contract. In this case, the contract failed to deliver the protection the borrower purchased. The borrower would have to read and understand all the fine print to understand these risks.
  • Swaps are very profitable for banks and are generally sold by a commissioned sales force. The individual incentives earned can be substantial enough to create a moral hazard at the individual banker level. Their personal interest may not align with the interest of the client. This is not disclosed. The incentives differ at every bank
  • The front line bankers themselves rarely have a full understanding of an interest rate swap transaction. The figures come from a wizard behind a curtain known as the "money desk" or "swap desk" or "derivatives platform". Even if the banker wanted to explain the exact economics to the client, they would generally not have the information or expertise to do so.
Please note that these comments relate to only the most simple form of derivative contracts. I would expect all the shortcomings I've identified to be magnified in larger and more complex transactions.