FT Alphaville " How NOT to argue that derivatives are the devil's spawn Every now and then, The New York Times takes a big ol" swipe at derivatives for being evil and whatnot. That's fine and well - and sometimes obligatory, particularly when it comes to certain structured products for which it's hard to discern the benefit to anyone outside of a bank. But it can all go awry when someone starts arguing against derivatives and just gets it wrong. It makes us do a sad, frowny face and then get incredibly frustrated. In the NYT on Sunday, there was an article entitled "How Banks Could Return the Favor" and we've been trying to figure out what they were on about since. It described (and we are de-sensationalising here) how a lot of municipalities issue floating-rate debt and also enter into interest rate swaps to turn the floating rate payments into fixed rate payments. Here's a diagram to illustrate: In short: the municipalities seek to minimise their cost of debt and the above structure is often the way to do that. However, as can immediately be seen in the above, if interest rates were to fall substantially, the overall structure becomes less beneficial for munis as there left paying a fixed rate that is increasingly above market rates. The NYT asks why, therefore, have the munis not refinanced their debt at lower rates? The bad news for taxpayers is that such easy refis are out of the question for many governments and agencies short on cash. And that's because these borrowers have been trapped by Wall Street. Behind all of this is - you guessed it - derivatives. Bankers have embedded interest-rate swaps in many long-term municipal bonds. Back when, they persuaded states and others to issue bonds and simultaneously enter into swaps. In these arrangements, the banks agreed to make variable-rate payments to the issuers - and the issuers, in turn, agreed to make fixed-rate payments to bond holders. Please re-read the last sentence one more time, and then compare to the above diagram... but we digress, the message is "derivatives are evil." Which is why, errr, corporates aren't silly enough to use them: Corporations rarely do deals like these, because they generally avoid making long-term bets on interest rates. But bankers sold the idea to public borrowers. The total bill to terminate all of these swaps-related deals would run into many billions. "Rarely"? Really? What's the source on that? We have no idea... so we went looking for one. Since the story speaks primarily to interest rate swaps ("deals like these"), let's assume that's the class of derivative under discussion. The International Swaps and Derivatives Association, an industry lobby group body, conducted a survey of companies in 2009 concerning their usage of derivatives. To be specific: The survey was conducted in March and April of 2009 using information reported in annual reports of the 2008 Fortune Global 500 and, in some cases, by contacting the companies directly. Of the 500 companies included in the Fortune Global 500, eight did not report sufficient information to make a determination. These companies were classified as not using derivatives. That seems a sound dataset and methodology to us. From the report, we're able to determine that 153 of the reporting companies were headquartered in the US. Here's a table from the report: From the above, 83 per cent of the biggest companies in the world use interest rate derivatives (which will include swaps, among other forms of rates products). We're going to guess that as companies shrink in size, the less likely they are to get involved in derivatives, but it hardly seems "rare." That said, the size that non-financial companies represent of interest rate swaps overall, is relatively small compared to financial companies. That's something that can be seen in statistics made available by the Bank of International Settlements. To further narrow it down within the BIS dataset, we just took "Interest Rate Swaps" and only those dominated in US dollars because we're generally curious about how active corporates and governments are in this market in the US: The corporates and governments ("non-financial institutions") in the above table are from all countries, but we're expecting some heavy representation from the US. Overall then, they represent about eight per cent of the total notional outstanding and four per cent of total market values. Therefore, on balance, while we expect a lot of corporates and government bodies in the US to be using interest rate swaps, and other derivatives, they are relatively small fry compared to banks and other financial institutions. As for the NYT's claim that "The total bill to terminate all of these swaps-related deals would run into many billions," we haven't a clue. We spent ages trying to think of ways to get a more accurate figure than the BIS data as it was lumping corporates and governments together, as well as not being specific to the US. We suspect they might be quoting (somehow) from a report they mention later on in the article that we're also going to discuss shortly. If you're curious about exactly where we looked, read the below section. The non-data-monkeys may skip. Places we looked and came away even more frustrated Trioptima - the old trade repository for interest rate derivatives. The breakdown is just G14 dealer versus non-G14 dealer and there are no market values. Also has amount contained in central counterparties (CCPs). DTCC - the new trade repository that's replacing Trioptima, has the same lack of detail as Trioptima. OCC - quarterly report on derivative activities doesn't have any counterparty information, but does have a lot of market value and risk exposure information. Isda Market Surveys - this have been discontinued, but the old ones didn't have any counterparty breakdowns. LCH.Clearnet - just has volumes, no further breakdown, and in any case not sure that they'd have information on clients who are transacting through a clearing member, but hell, we were getting pretty desparate by this point. By now we have made it to the sixth paragraph of the NYT article and we are already exhausted. The rest of the story heavily leans on this report produced by the Refund Transit Coalition (click to open the report): While it isn't going to win any awards for even-handed language, we didn't find any big glaring inaccuracies in sentences which were presented as facts. There's a lot of strong opinion, but overall it seems well-researched. There are even 138 endnotes accompanying the 20 pages of text, and those contain links to the sources used. The examples of swaps, and there are quite a few, appear sound, if cherry-picked (but again, transparently so). There's even this accurate diagram: To summarise the message of the report in our own words (again, we'll de-sensationalise) ... "It's true that a lot of these deals looked to be in the munis" best interests in terms of costs when they were entered into. We get that if interest rates went up, these hedges would have been profitable for the munis. But that's not what happened. Instead, the Fed lowered rates in response to the financial crisis, while the banks were also very directly bailed out. The Fed doesn't intend to raise rates anytime soon. Also there are allegations that some banks acted in such a way as to keep LIBOR down, which if true, has exacerbated the losses on the swaps held by the munis. In our opinion, it's unfair that banks got bailed out by taxpayers and now they are on the winning side of bets that are costing taxpayers a lot of money, at a time when transit authorities are having to cut key services and go through layoffs. It's hard not to feel at least a little sympathetic. That said, banks also (in the legal sense) have a fiduciary duty to shareholders. How are they to pick which deals and contracts to just let their counterparties off when they would otherwise make money on them, assuming that these were done in good faith? It's not so straight-forward. However, that's not to say any bank client, particularly ones that do a lot of business with banks, should roll over and play dead. By all means, seek to renegotiate deals. Have an open and transparent competition between banks for any and all business. Play some serious hard ball. Hell, bust some balls. The report has a list of examples (page 19) of municipalities that have already done this. If you work for a muni, why not call those who were successful and ask how they did it? Should you win the battle, why not write about it? Footnotes and visible sources much appreciated. Related links: Any Given Sunday... - ISDA media.comment How Banks Could Return the Favor - NYT This entry was posted by Lisa Pollack on Wednesday, June 13th, 2012 at 14:13 and is filed under Capital markets. Tagged with interest rate swaps, interest rates, Municipal bonds, Municipalities.