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.

Credit Value Adjustment

Credit Value Adjustment or CVA has been around for a long time, however, with the introduction of the accounting standard IFRS13, this year there is a requirement to understand it a bit better. The new standard requires the CVA component to be separately reported from the fair value of a financial instrument.

CVA is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk.

The big question is whether it will be material enough for most organizations to worry about; given the potential complexity around its calculation, most would hope not.

There is no doubt if you have cross-currency swaps the impact of CVA is likely to be material. However most companies that use these instruments would normally have a sophisticated treasury management system that would do this calculation at the push of a button.

Most other organizations however will probably be relying on spreadsheets to capture and record their treasury transactions and will lack the ability to calculate financial instrument valuations let alone the more complex CVA.

Will you need to worry about CVA is the question? Most do not know there is a requirement, let alone how it will be calculated and this is true of the audit profession as much as the corporate world.

Whether it is material or not may be the question, however, it is likely that even if it is not material there may be a requirement to prove this. At the end of the day the audit profession will decide whether organizations will need to calculate CVA or not. In the meantime we are keeping a watching brief on both the banks’ ability to provide the CVA component and the audit firms as to whether they will force organizations to calculate it.

Watch this space.

Will Central Banks Keep Easing?

As the calendar turned to 2013, all was seemingly well: Chinese “hard landing” concerns eased substantially, with growth settling near +8% annualized; the Bank of Japan’s new ultra-dovish mandate under the eye of new Prime Minister Shinzo Abe was sending the Japanese Yen plummeting, reviving the carry trade; peripheral European sovereign yields remained low and relatively compressed to their German equivalents, allowing the Euro to outperform every major currency; and U.S. politicians struck an eleventh-hour deal to avoid the fiscal cliff, the self-induced austerity measures intended to quickly cut the budget deficit.

But those were only near-term developments, 2012, like 2011, was marked by substantial volatility across asset classes, all thanks in part to unstable and unpredictable political issues in Europe. And yet here we are, in mid-February, with equity market in the United States nearing all-time highs, and (gasp!) there’s even talk about the Federal Reserve winding down its stimulus program later this year. With uncertainty so prevalent over the past several years, it’s quite miraculous where global markets actual stand; but it’s also clear that there must be another force at play.

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This exogenous factor, that seemingly has elevated the mood of all market participants, has been the additional liquidity provided by the world’s major central banks, in programs most commonly executed as a variation of quantitative easing, or QE. This process entails central banks increasing the money supply of their currency, for two main purposes: to lend to banks at ultra-low rates to incentivize them to lend the borrowed funds back to consumers and businesses, to help foster economic growth; and to weaken the domestic currency to help improve the competitive export position – a weaker domestic currency makes domestic products cheaper for foreigners. While this second point may be true, the first point, not as much; instead, much of the cheap liquidity has been the ammunition market participants need to partake in risky financial activities, which has sent the S&P 500 on its way to all-time highs.

Certainly, there is some clout to this argument. Over the past three years (since the first week of February 2010), the S&P 500 has rallied by +42.15%, while the major global central banks’ balance sheets (the Federal Reserve, the Bank of Japan, the European Central Bank, the Bank of England, and the People’s Bank of China) have increased by +38.42%. There’s a simple inference: only +3.74% over the past three years in the S&P 500 can be attributed to ‘organic’ economic growth, as the rest has been fueled by ultra-loose monetary policies being implemented across the globe.

But as we said to begin this post, 2013 began on a high note; many of the concerns plaguing the investing environment were resolved or swept under the rug, out of sight, out of mind. As the globe’s major economies improve, central banks will begin to drain out the excess liquidity in the system. Is the global market stable enough to withstand such a series of events?

This series of eight posts will focus on the major themes affecting currency markets. The next two posts in this series will focus on the United States’ monetary and fiscal policies, and how they could upend a slow economic recovery.

The Euro-zone Crisis: Goldman Sachs, Greece, and Swaps

This is part 8 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 8, we’ll discuss the role of swaps in more recent times: the Euro-zone crisis.

In June 2001, seeking to shore up its finances as it prepared to use the Euro as a member of the Euro-zone currency union, Greece reached a deal with the U.S. bank Goldman Sachs to borrow €2.8 billion.  When the deal was reached, the Greek government had already owed Goldman Sachs about €600 million – not counting the €2.8 it just borrowed.

Just four years later, the costly transaction nearly doubled to €5.1 billion. It turns out that a currency swap agreement was in place to help conceal Greece’s haphazardly constructed balance sheet, which showed that the country was experiencing an unsustainable rise in its debt-to-GDP ratio. Without the deal, Greece wouldn’t have been able to join the Euro-zone, as its debt-to-GDP ratio was in breach of the European Union’s rules for the amount of debt each country could have in order to join the Euro. But a loophole in the law allowed the currency swap agreement in place to not be counted as debt, thereby keeping Greece’s debt-to-GDP ratio within the European Union’s required range.

The arrangement made in June 2011 had two key components. The first was a series of currency swaps. Greece’s debt, which historically was accounted for in Japanese Yen and U.S. Dollars, was converted to Euros for the transition into the common market. Instead of the contracts being transacted at the spot exchange rate, they were measured against a fake exchange rate devised by the Greek government and Goldman Sachs – a perfectly legal move, given accounting rules in the European Union at the time.

Because of the positive value that currency swaps had for Greece, the government needed to pay back what was, for all intents and purposes, a loan from Goldman Sachs. In a separate deal, Greece entered into an interest rate swap which yielded a positive value of €2.8 billion to Goldman Sachs, including €400 million in fees for unwinding other swaps Greece had entered. In its truest sense, this was a fixed-for-floating swap: Greece would send floating-rate payments to Goldman until 2019, while Goldman Sachs would happily send fixed-rate payments to Greece.

Perhaps the best analogy for what happened to Greece is what happened with the U.S. housing crisis. Part of the deal with Goldman Sachs was a two-year period in which Greece would not have to make any payments, similar to what is the teaser rate period. As history showed, without the benefit of rising housing prices, subprime borrowers couldn’t refinance within the teaser window (in which rates were low before springing to unsustainably high levels, hence the housing crash).

Like the teaser loan rates enjoyed by subprime borrowers in the U.S., the payment-free period enjoyed by Greece made it seem like the country’s finances were fine, because the country didn’t have any debt obligations for two-years. Instead of hoping for rising house prices, the Greek government was hoping that an economic boom would spur higher tax receipts, which the government could use to pay down the cost of the currency swap.

While the Greek government enjoyed low borrowing costs, the repercussions were building on the horizon: the deferred interest would have to be paid eventually. In 2005, as noted earlier, Greece was forced to refinance the loan, bringing the total cost of the deal to €5.1 billion. This “actively managed tweak,” as described by Eurostat, allowed Greece to keep the loan a secret, thereby keeping its debt-to-GDP ratio within the European Union’s mandated range. After Greece refinanced its debt, Goldman Sachs sold its obligation to the National Bank of Greece, at a marked-to-market value of €5.1 billion.

But these are just large numbers – why do they actually matter? When Greece initiated the original transaction with Goldman Sachs, it had publicly issued 10-year bonds with a coupon rate of 5.35%. Some quick math: compounding this rate over four years (to 2005), Greece would have owed €3.4 billion; instead, the €5.1 billion obligation represented an astounding 16.3% (!) annual interest rate.

Instead of bringing this issue to light immediately, the government chose to hide the mistake further, extending the maturity of the loan another 18 years to 2037. But by 2010, the costly repayments were too much to handle, and Greece was forced to reinstate the debt onto its balance sheet: the Greek debt crisis was born. Today, it is widely expected that Greece will default on its >€300 billion of obligations, forcing it out of the Euro-zone and back to using the Drachma, Greece’s pre-Euro currency.

In part 9 of 10 of this series, we’ll discuss recent regulatory efforts as a direct result of costly mistakes that have piled up over the past several years directly related to swaps.