Swaps lead to teardrops

Cees Smit, Columnist Faces

In my last column I talked about bashing the banks. This story just continues. If we look at the media now, then again, politics sides with the poor entrepreneurs and thus against the banks in the discussion on interest rate derivatives (swaps).

For those who missed, many entrepreneurs make use of credit supplied by the banks in order to finance their business. For example, to finance the property in which the company is located. A few years ago, before the onset of the credit crisis, the prevailing view was that inflation would arise and consequently that interest rates would rise. Even after the credit crisis some “gurus” still strongly claimed that inflation / higher interest rates would arise because of all government stimulation (i.e. pumping money into the system). These higher interest rates have negative effects on the private sector; after all, companies face higher costs and lower profits. However, the problem of high interest rates can easily be solved by hedging against high interest rates yourself by means of an interest rate swap for example In an interest rate swap you trade a high interest rate against a low interest rate.
Swapping is the exchange of cash flows and it is, just like many other derivative products, a great tool. However, the frustrating aspect is that it often costs you a lot of money if things work out differently than you expected.   In that case, you will experience what my mother already pointed out to me when I was a child: swaps lead to tears.

We are now in a situation in which the central banks (read: politics) keep the interest rate at an extremely low level, in the hope to get the economy going again. The interest rate is even that low that discussions about the introduction of negative interest rates arise amongst the managements of central banks in the media Negative interest rates mean that people need to pay money in order to store money.

This all seems very nice, because this implies that you will get extra money if you borrow. But the consequences of negative interest rates, and even with the current (zero) interest rates, are gigantic. There is an attack on the value of pensions on the one hand, but in light of the swaps as just discussed, it is much more important that anyone who has hedged against a higher interest rate via an interest rate swap, now suddenly experiences the negative impact of low interest rates as one is obliged to pay extra the interest rate difference under a certain level (e.g. three percent). In this construction, one faced an upper bound of, say, five percent, so that all rates above five percent do not have to be paid for.

The interest rate hedge now works against the entrepreneur, but was discussed with auditors and other financial experts in many cases. Thus it is not per definition correct to say that a large knowledge gap existed and that the ‘poor’ entrepreneur was palmed off on a poorly understood financial product.  Expectations were undoubtedly very positive and no one took into account a situation in which the interest rate could be very low for a long time. But is this per definition the fault of the banks? In England banks are already sentenced, due to the prevailing public opinion. ‘Lady Justice’ losses her blindfolds quite soon already, as it seems, and is then anything but blind.

More importantly, however, investors and companies lack any sense of historical awareness, as they should know that something went wrong with derivative products a couple of times in the past. This was always due to not taking into account all possible scenarios or to underestimation of the so-called tail risk, which seems strange considering that derivatives are fantastic tools to take advantage of the latter. I will give an example of what is worrying me and that shows we have not learnt from the past.

Portfolio Insurance 2.0

During the 1987 market crash stock markets were sharply declining.  Declining stock markets in itself were not so special, as they had occurred more often. But what was really special about this one, was that banks and asset managers thought to be clever by coming up with the idea of Portfolio Insurance, i.e. protection against downward pressures on a portfolio. It would be done by selling Futures (a derivative on the index) when the stock market went down. The problem was that everyone started selling at the time the stock market was declining. A correction led to the severe market crash.

Companies like ALEX asset managers now advertise with the promise that they are changing to cash if the stock market goes down. So, they are going to sell when the stock market is falling. Other asset managers nowadays often work with volatility models. This means that if the volatility increases, less money will be invested in equities. This will lead to a reduction in risk, but as a consequence, one needs to sell when the index drops. In a crash the volatility increases enormously, since it is an unexpected move, a deviation from the normal trend, which will trigger a big selloff.

In short, you could ask yourself the question: what about the ability of people to learn from mistakes made in the past?