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  • Betting the House (of Cards) on Interest Rate Derivatives 0 comments
    Mar 11, 2010 10:43 AM

    Betting the House (of Cards) on Interest Rate Derivatives




    Nathan Kawaguchi


    Previously, we wrote a piece called, “Interest Rate Derivatives – A $437 Trillion Time Bomb?”  In that article, we gave an overview of our basic points of concern.  The sheer size of the interest rate derivative market caught our attention, especially since the $62 trillion credit default swap (CDS) market was a major factor in our recent financial crisis.  In this follow-up article, we will examine some of our specific concerns and begin to offer some suggestions on how to mitigate the risk.

                As we stated in our previous article, there were approximately $605 trillion outstanding notional amount of over-the-counter (OTC) derivatives as of June 2009.  $437 trillion of this amount was interest rate derivatives.  In conversations and email exchanges with people who have considerably more knowledge and experience with derivatives, we are told by some that our concerns over the staggering notional amounts are overdone.  This is explained because, unlike credit default swaps, no one is on the hook for the actual notional amounts.  Notional amounts are really more of a reference point for the amount of the cash flow being exchanged.  Fair enough.  We are also told that derivative books are marked to market daily and sometimes multiple times daily, if needed.  This is supposed to ensure control of risk through collateral requirements and real-time credit risk evaluation.  This is fine for small incremental movements.  But what happens if there are dramatic unexpected movements?  Considering the large notional amounts and currently low interest rates, could counterparties come up with the collateral without dislocating global markets as in the recent crisis?

                Before we express our more specific concerns about interest rate derivatives, we want to make something very clear.  We have no conflict of interest in expressing our negative opinions on the matter.  We are not big enough in size or name to access or influence this market directly.  Nor do we have any directly correlated hedges or bets from which to gain financially in the event of a collapse.  In fact, we hope we are dead wrong and that our concerns stem from our rather elementary understanding of derivatives.

                There are a few specific features of the interest rate derivatives market that are particularly troubling to us.  First, does $437 trillion in notional debt even exist?  After all, isn’t an interest rate swap really just an interest rate hedge—a form of insurance?  The whole concept of insurance requires an insurable financial interest.  Anything beyond an insurable interest is a speculation on an outcome. 

    According to the Federal Reserve Board’s December 10, 2009 Statistical Release, there was approximately $53 trillion in total U.S. credit market debt outstanding at the end of the third quarter 2009.  Let’s assume that every single U.S. debtor was unhappy with their original loans and entered into interest rate contracts such as swaps.  What’s the other $384 trillion of interest rate derivatives insuring?  Sure, the $53 trillion only includes debt of people, companies and governments of the United States.  While we could not find reliable figures for total worldwide debt, we find it hard to believe that the rest of the world accounts for the remainder (We did find unverified estimations of total worldwide credit market debt around $100 trillion).  Even if we include all other liabilities (bank deposits, money markets, repos, insurance, pensions, etc.), total U.S. liabilities add up to approximately $111 trillion.  Again, assuming every single penny of notional is swapped, that still leaves $326 trillion to be absorbed outside the U.S. or by speculative interests.

                The second observation that gives us concern is the amount of interest rate derivatives handled over-the-counter.  The $437 trillion OTC market dwarfs the $69 trillion of exchange-traded notional amount (as of September 2009).  OTC markets are sometimes opaque and more difficult in which to implement and enforce prudent risk controls.  If so much is done OTC, how can we be sure there are proper controls to mitigate systemic risk?

                Another cause of concern is the concentration of counterparty risk.  While “too big to fail” is often cited as a key reason for the financial collapse, one would think we’d make an effort to change that.  The reality is the situation has not gotten any better.  In fact, it has become worse in some respects.  The Bank for International Settlements (NASDAQ:BIS) publishes the Herfindahl index, which is a measure of market share concentration.  Since the peak of the credit crisis, the Herfindahl index for interest rate swaps has actually increased for markets in every major currency except for the Euro, which saw a modest decline.  In many currencies, the index climbed significantly.  This indicates a further concentration of risk, which increases systemic risk and moral hazard under the paradoxical “too big too fail.”

                The other major area of our concern is the use of Value-at-Risk (VaR) in capital adequacy calculations.  As David Einhorn pointed out in his debate with Aaron Brown in the June/July 2008 issue of Global Association of Risk Professionals, risk models such as VaR are flawed because they disregard long-tailed events.  In a common VaR calculation, a firm may figure its daily VaR at a 99% threshold.  If a firm expected a disruptive change in interest rates that historically occurred once every 10 years, the odds of that change on any given day are 1-in-3650.  In other words, it would have a 0.03% chance of occurring, which is outside even a 99.5% threshold.  The VaR model renders this probability statistically insignificant.  The trouble here is that our financial world is growing increasingly complex and these multiple-sigma events seem to pop up more frequently than historically-charged statistics would suggest.  What if you were very confident that a “perfect storm” would strike once every 15 years (1-in-5475 days)?  You wouldn’t disregard it because it only has a 0.02% chance of occurring on any given day.  You would prepare for something like a 50% or 75% chance of occurring over any given 15-year period, or at least a 6.67% chance in any given year.

                The last major concern we have is related to asymmetric interest rate risk.  Interest rate swaps have a zero value at inception because they are based upon future interest rate projections implied by the swap yield curve.  Interest rates, as far as we know, can only go to zero.  However, they can theoretically go infinitely higher.  While it’s not highly probable, it’s neither inconceivable to envision interest rates similar to those of the early 1980s.  Even having rates return to historical norms would place a tremendous burden on the counterparties holding the variable legs of long-dated interest rate swaps.  Most swaps are based on the London Interbank Offered Rate (LIBOR).  One- to 12-month LIBOR rates were recently 0.23% to 0.85%.  In October 2008, these rates were around 3.80% (There is also some controversy surrounding the reliability of LIBOR rates as reported by the participating 16-bank panel during the credit crisis).  Even a return to pre-crisis levels of around 5.00% could spell danger for the receiver (who pays the floating rate).  If we take an average current LIBOR rate of 0.50%, that is a 10-fold increase!  Additionally, LIBOR rates incorporate the perceived creditworthiness of participating banks.  We wonder whether or not these assumptions are considered when risk managers look at their VaR models, especially when considering thin capital ratios.

                Some readers must be thinking by now, “Okay, if you’re so smart, then what’s the solution?”  We would be foolish to presume we have all of the right answers.  We have neither adequate knowledge nor experience in this field.  But we do have enough common sense to examine our major concerns. 

    We need to address systemic risk and break up firms that are “too big to fail.”  Bringing back something similar to Glass-Steagall would be a good place to start.  We need to further address systemic risk by encouraging more competition, which would spread the concentration of counterparty risk.  We suspect that swap dealers could effectively be “sleeping around” by entering into offsetting contracts with each other—similar to the monoline insurers reinsuring each others’ exposures.  Worse yet, we also suspect that swap dealers could be entering into offsetting contracts with their own subsidiaries—very similar to the offloading of illiquid assets into Special Purpose Vehicles (SIV) and the like.  Of course, this is merely speculation on our part.

                We also recommend implementing some uniform standards for “plain vanilla” interest rate swaps that could be cleared centrally through various participating clearing firms.  This would provide much-needed transparency to this market and create standard products that parties could more readily understand.  With central clearing, it would also be much easier to institute uniform margin and/or capital requirements similar to those of more traditional securities dealers.  And there would still be a need and place for more customized contracts to trade OTC.

                We are sure to have more bones to pick with the interest rate derivatives issue, but we run the risk of losing our readers’ attention continuing this particular article any further.  Look for more in the near future.  Similar to our first article, we welcome any additional input or insight that would help us refine our understanding of this market.

    For more information, visit us at

    Disclosure: No Positions
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