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This article was published 11/6/2010 (2625 days ago), so information in it may no longer be current.
55Yet, the average investor has nothing to do with it -- at least directly.
These investments, which are not listed on any exchange, are privately traded between two parties, usually banks, hedge funds, pension funds, governments and large corporations. And while OTC derivatives come in just about every shape and size, swaps are the most widely traded.
According to the Bank for International Settlements, which tracks derivative trades globally, swaps make up more than half of the $614 trillion worth of derivative contracts held at the end of last year.
"Most people aren't even aware that these exist, but they absolutely dwarf the value of the equity market," says Alan Fustey, a chartered financial analyst and portfolio manager with Index Wealth Management in Winnipeg.
It's a fair question, at this point, to ask: If I'll never own one of these investments, who cares? Unfortunately, in the increasingly interconnected world that we live in, even those investments that have nothing to do with our day-to-day lives can have a profound effect on our economic well-being.
And swaps are no exception. One instance, in particular, has recently negatively affected just about everyone and that is the credit crisis of 2008/2009.
While that meltdown had its origins in the subprime real estate market in the United States, the faulty loans trickled upward into the derivatives market, and swaps -- credit default swaps -- played a large role in nearly blowing up the world's banking system.
So just what is a swap? It's a simple enough concept that can be contorted and customized to make it so complicated that even professionals have a hard time figuring out how some deals work.
"Swaps are kind of all based on the same principle," says Trevor Radomsky, a former trader at a derivatives desk with a Canadian financial institution.
"What you're doing with a swap is swapping the performance of one security with the performance of another similar security."
Swaps can be done with bonds, stocks, currencies and even options. But the most common swap is an interest rate swap. Banks and other large-scale investors will often swap the interest payment they receive on a fixed-income investment like a bond, for the interest payment another investor receives on a fixed-income investment of the same principal amount. Usually, it involves swapping a fixed-interest payment for a variable-interest payment. For instance, a company is receiving five per cent interest per year in payment on $10 million worth of five-year bonds.
But the company has to pay expenses based on a variable interest rate and it forecasts interest rates will rise over the next five years -- higher than five per cent. To protect against rising rates, it hedges its risk -- or neutralizes the effect of a rising rate.
The company can use a swap to trade its fixed-rate payment for a variable-rate payment with another company. In the OTC world, the company on the other side of this trade is called the counterparty.
"It's basically like you go out and buy a bond and it pays you a fixed coupon of five per cent and you think to yourself, 'Now I think rates have bottomed and inflation is going higher, central banks around the world will be raising rates like Canada just did,' so you want to take the fixed coupon that you're receiving every month, and instead of receiving a fixed rate, you want to get a floating rate," Radomsky says.
The swap accomplishes two things for the company. It allows the company to maintain ownership of the bond. It doesn't have to sell the bond at a reduced price to buy a new one with a better coupon (interest) rate. With a swap, the company keeps the fixed-interest payment bond, but it gets the benefit of a floating rate -- so long as interest rates rise. If rates don't increase, the company might end up with lower variable interest payments than it would have received with a fixed rate. But because it has expenses at a variable rate, its interest rate risk is hedged because its interest income is at the same rate.
Practically every major banking institution will give another financial institution, corporation, pension fund or hedge fund a swap on an investment.
"You can go to Goldman Sachs, JP Morgan, CIBC or Royal Bank of Canada and say, 'Hey, I've got $100 million worth of bonds that I want to swap a fixed rate for a floating rate,'" Radomsky says. "They'll take the other side of your trade, but in fact, they may have the same view as you that rates will go higher, so they'll go into the third party broker market or call another bank and offset the swap again."
With each swap, the bank will offset risk so it has virtually no money to lose. Instead, it sets up deals with a small spread that provides higher earnings on one deal than it has to pay out on the other deal.
"A bank will say, 'My liability to you is $4.80 and I'm receiving $5 from the other guy on the other end of the bet," Radomsky says. "They'll price it in a way that they make money. They won't do it for a loss."
For the most part, swaps help reduce volatility for companies and institutional investors. They are a risk-management tool. But they can also be used recklessly -- like another contentious human invention.
"Swaps are like guns. Guns don't kill people. People do," Fustey says. "Swaps are used for hedging for legitimate purposes and some are used for speculation -- and there's nothing wrong with either one of those things."
Fustey says the speculator can make money in two ways. "There's just the pure credit default swap where one side pays money to the other side to insure that if the bond goes sour before maturity that they get made whole. If I'm selling that insurance, I'm betting that the bond won't default and I get to keep all those premiums. So I'm speculating.
"On the other side, I don't own the bond, but I'm betting that the company is going down. So, I'll pay a small premium and if the company goes bankrupt, guess what? You have to pay me on the whole bond, even though I don't own the bond."
When they're misused, even the smaller ones -- at least compared with half-a-quadrillion dollars -- can cause system-wide upheaval. A recent example is the infamous swap deal Greece had with Goldman Sachs. This complicated swap -- involving currency and interest rate swapping -- allowed Greece to delay debt payments in 2001. At the time, its deficit was too high to meet the requirements for entry into the European Union, so it effectively swapped out short-term payments for long-term to reduce its deficit to gain entry.
Today, Greece faces an even worse financial situation that threatens the entire union and has prompted Germany to bail out Greece.
While it's not the swaps themselves that cause problems, the lack of transparency in the way they are traded can be troublesome, Fustey says. Because they're not listed on exchanges, swaps and other OTC trades can be kept off the accounting books until they are settled. Nobody knows just how deep the sinkhole of losses is until one of the parties involved comes clean. The role credit default swaps had in the 2008 credit crisis (see fact box) is a good example of how insidious derivatives can be when markets go in a direction most people didn't foresee, including derivative traders.
"If you take this far enough, you can see how this becomes a house of cards," Fustey says, adding this is why it's even hard for mutual fund investors to remain unaffected sometimes.
"Unfortunately, the world is more connected than it ever has been and the difficulty is that investors can't isolate themselves from certain pockets of the market."
So just what is a credit default swap?
Often referred to as a CDS, it's like insurance for a fixed-income investment. Generally, they're sold for bonds to protect against default. The bondholder -- the owner -- pays a premium to a financial institution to ensure the principal will be paid back at maturity, says CFA Alan Fustey. The price of the credit default swap is based on the likelihood of the bond defaulting. The higher the chance of the bond issuer defaulting, the higher the cost of CDS will be. The premium cost is often called a CDS spread, and spreads are expressed in basis points. One basis point is one one-hundredth of a per cent. For instance, Greek five-year bond CDS spreads have been higher than 900 basis points recently, meaning a bondholder would have to pay more than $900,000 a year to insure a $10-million principal if Greece defaults.
What role did credit default swaps play in the 2008 meltdown?
In 2008, AIG was one of the world's largest insurers. It had a small investment branch that sold credit default swaps. It sold billions of dollars worth of CDSs for U.S. mortgage-backed securities, guaranteeing the principals on these fixed-income investments. "For a long, long time the money was good and there were no credit issues," says Fustey, adding AIG -- like many other companies -- assumed the U.S. real estate market wouldn't stop growing. "(AIG) could keep taking in the premiums and there were no worries. But then -- BOOM!" The real estate market began to slip, starting with subprime mortgages, which made up a portion of most mortgage-backed securities. The falling value of these investments brought down two major U.S. investment banks -- Bear Stearns, which was bought out, and Lehman Brothers, which collapsed. Many investors in Lehman had AIG credit default swaps to protect against Lehman defaulting. But AIG had sold more of this insurance than it could pay out to cover Lehman's default. AIG wasn't alone, though. Counterparty risk with credit default swaps and the underlying mortgage-backed securities was so high, governments allowed many companies to suspend mark-to-market accounting rules in the spring of 2009. Otherwise, they would have had to report their losses and settle up. "They basically told the banks, 'Just ignore that for the time being,'" Fustey says. "We know your investments are only worth a few cents on the dollar. Don't worry about it and then your capital is still good."
A notion on derivative values: The more than $600-trillion worth of derivative deals floating about can be somewhat misleading. The total amount is a notional value, which refers to the face value of the principal on which payments for the derivative is based. For example, the notional amount on an interest rate swap on a $10-million bond is $10 million. But the only money exchanged in the deal is the interest payments, which are much less. The gross market value of the derivatives -- the actual money that changes hands when they're settled -- is about $21 trillion. -- www.bis.org