End of year derivative valuations improve for borrowers

The increase in interest rates over 2013 means that the 31 December 2013 valuations of borrower derivatives such as interest rate swaps will look much healthier compared to a year ago. The global economy certainly appears to have turned a corner through 2013 and this is being reflected in financial markets expectations for future interest rates i.e. yield curves are higher. As interest rates collapsed after the onset of the GFC many borrowers took advantage of what were, at the time, historically low levels. Base interest rates i.e. ignoring credit, were compelling and borrowers increased their fixed rate hedging percentages locking in swap rates for terms out to ten years. Unfortunately, as the global economy sank further into recession, interest rates fell further than most market participants expected. Consequently, derivatives such as interest rate swaps moved further out-of-the-money creating large negative mark-to-market positions.

The unprecedented steps taken by central banks in an effort to shore up business and consumer confidence, protect/create jobs and jump start lack lustre economies pushed interest rates lower for much longer. Through 2013 the aggressive monetary policy easing undertaken since 2008 (by the US in particular) has started to show signs that the worst of the Great Recession is behind us. The Quantitative Easing experiment from the US Federal Reserve’s Chairman Ben Bernanke appears to be a success (only time will confirm this). The labour market has strengthened, as well as GDP, in 2013 allowing a gradual reduction in Quantitative Easing to begin. Although the US Central Bank has been at pains to point out that the scaling back of QE does not equate to monetary policy tightening, merely marginally “less loose”,           the financial markets were very quick to reverse the ultra low yields that had prevailed since 2008.   The US 10-year treasury yield is the benchmark that drives long end yields across every other country so when bond markets in the US started to aggressively sell bond positions, prices dropped and yields increased globally. As the charts below show all the major economies of the world now have a higher/steeper yield curve than they did a year ago reflecting expectations for the outlook for interest rates. For existing borrower derivative positions the negative mark-to-markets that have prevailed for so long are either much less out-of-the-money, or are moving into positive mark-to-market territory.

Of the seven currencies that are included in the charts below, all display increases in the mid to long end of the curve i.e. three years and beyond, to varying degrees. Japan continues to struggle having been in an economic stalemate for 15-years so the upward movement in interest rates has been muted. The other interesting point is the Australian yield curve which shows that yields at the short end are actually lower at the end of the year than they were at the start of the year. Australia managed to avoid recession after the GFC, a beneficiary of the massive stimulus undertaken by China and the ensuing demand for Australia’s hard commodities. However, as China’s economy subsequently slowed and commodity prices fell, the recession finally caught up with Australia and the Official Cash Rate (OCR) has been slashed in 2013, hence short-term rates are lower than where they started the year.

As 31 December 2013 Financial Statements are completed there will be many CFOs relieved to see the turning of the tide in regards to the revaluation of borrower derivatives.

2012 to 2013 yield curve movements

Mis-selling of swaps case dismissed

Further to our article posted last week, there has been more evidence to confirm that borrowers crying about “mis-selling” of swaps is not going to garner sympathy in the courts. A sophisticated borrower, or an entity with access to expert advice, cannot lay blame at the door of the banks for their own misjudgments for what have been in hindsight poor hedging decisions. http://bit.ly/1at7pk0

It’s risk management stupid

The bankrupted City of Detroit is locked in a legal battle over the purchase of interest rate swaps as are many other municipalities/local governments around the world. Detroit’s case is particularly high profile given the tragic demise of a once great city, and as with most bankruptcies not everyone appears to be treated equally or indeed fairly.

The numbers that relate to the interest rate swaps are enormous, which is no doubt why Detroit feels so aggrieved. These numbers are also, not surprisingly, losses, and indeed realised losses as the bankruptcy will result in the closing out of these swaps. But whose fault is it really, the banks for selling these swaps or the municipality for purchasing them?

Everyone likes to bash the banks and indeed they may not be blameless in this case. If the banks are withholding information or forcing the entity into purchasing the swaps as part of the underlying transaction then this doesn’t seem right. However, whether you are a large municipality in the US or a dairy farmer in New Zealand the onus is on the buyer of these products to understand the risks associated with them before they transact. It is difficult to believe that a finance team that is sophisticated enough to issue millions of dollars of bonds does not understand the mechanics of an interest rate swap.

Interest rate swaps are risk management tools. They can be used to give certainty of interest cashflows for entities that are perhaps highly geared and therefore cannot afford to pay any higher interest rates or can also be used as a proactive way of managing interest rates. Portfolio management dictates that a proportion of debt should be fixed either through fixed rate borrowing or interest rate swaps but the financial markets are not a one way bet, otherwise we would all be millionaires. There are risks attached to entering these transactions. As is often the case we hear of the cases where rates have gone against the swap owner but not so much when it has gone the other way.

Interest rate swaps are not toxic or necessarily dangerous. They should though be used by those who understand them. The various scenarios that can play out depending on movements in the financial markets should be modelled. Interest rate swaps also have the flexibility of being able to be closed out as part of the overall risk management strategy if necessary.

As with any purchase the buyer needs to know what they are buying. With swaps they need to form part of the overall risk management approach. We would all like the opportunity to try and renegotiate the whys and wherefores of entering into a financial instrument when the markets move against us. Swaps can be complicated but are also useful risk management tools that have a place in any borrowers or investors risk management strategy. Lack of understanding should not be a defense against decisions which in hindsight may not have been made.