Swap Fever: Big Money, Big Risks

Just one day before Olympia & York Developments Ltd. filed for bankruptcy protection, an unusual auction notice appeared deep in the back of The Wall Street Journal. In 11 inches of minuscule type, the advertisement invited blue-chip banks to bid on some of the most sophisticated financial vehicles around: a string of big interest-rate swaps between O&Y and Japan's Dai-Ichi Kangyo Bank Ltd.

The seller was Morgan Guaranty Trust Co., which had seized the swaps when O&Y defaulted on a loan to Morgan and seven other banks. All in all, O&Y had some $1 billion worth of swaps outstanding. Although Morgan's swaps, which had been pledged as collateral on the loan, were worth an estimated $10 million, O&Y owes nearly $80 million on its other swaps to banks and dealers.

Virtually unknown just a few years ago, swaps and related "derivative" instruments have become a key--and increasingly controversial--component of the capital structure of major financial institutions and corporations. In essence, a swap is a risk-transfer mechanism, an exchange of payment obligations between two parties--for instance, fixed-rate for floating-rate interest payments. From a handful of rudimentary deals in the 1970s, swaps have mushroomed into one of the largest and most efficient financial markets on earth (chart).

With some $5 trillion in contracts outstanding worldwide, the size of the swaps market now eclipses the value of all the shares listed on the New York and Tokyo stock exchanges combined. Swap portfolios amounting to hundreds of billions of dollars are becoming commonplace, with Morgan alone boasting $355 billion in deals, some two-thirds of them arranged offshore. "It's a totally global business," says Peter D. Hancock, a Morgan managing director.

In this global bazaar, longstanding regulatory barriers and distinctions among equity, debt, and commodities are being cast aside in a whir of often-esoteric financial engineering. Hunched over souped-up Sun Microsystems Inc. workstations, $500,000-a-year swappers now bombard the likes of AT&T, McDonald's, and Ciba-Geigy with custom-designed deals. With a few taps on a keyboard, traders transform fixed-rate dollar loans into yen-denominated floaters, or make Treasuries behave like the Standard & Poor's 500. They can even create a "synthetic" security that replicates the cash flow of a real oil well. Marvels Nobel laureate and University of Chicago economist Merton Miller: "You can make almost anything out of anything."

But as swaps have blossomed, so has concern about their potential drawbacks. With banks still bleeding from their disastrous forays into Latin America and real estate, notes New York Federal Reserve Bank President E. Gerald Corrigan, speculation in swaps may be the industry's next big problem. "High-tech banking and finance has its place, but it's not all it's cracked up to be," he warns. Rather than reducing risks, swaps may even be "introducing new elements of risk into the marketplace."

THE CRUNCH NEXT TIME. Chief among those risks, others contend, is the swap market's expanding web of interconnections. Some fear swaps could eventually transmit financial shocks from market to market and country to country at frightening speeds. Most swap deals are unsecured and exposed to ever-more-volatile interest-rate, currency, and futures markets. If an institution en one side of a swap is unable to keep up its payment, then the counterparty on the other side may have to suspend payments. Under extreme conditions, that could lead to a broad seizing-up of the market.

Central bankers and an increasing number of senior industry executives also worry that no one really understands the full scope of what's going on. The market is highly secretive. Most deals are arranged off corporate balance sheets and seldom disclosed publicly. "Where will the next credit crunch be?" asks economist Henry Kaufman. "We're not even out of the current one, but the next one will be in derivatives."

Such concerns are based on the bitter experience of several near-disasters. Since 1988, regulators in Britain, New Zealand, and the U.S. have had to scramble several times to keep money markets functioning after swappers went under. Federal Reserve officials, for example, were obliged to move onto trading desks in Boston and on Wall Street to help unravel the billions in swap deals left behind by the failures of the Bank of New England Corp. and Drexel Burnham Lambert Inc. Drexel alone had $30 billion in swaps on its books. Its collapse "almost upset the whole global payments system," says Alexandre Lamfalussy, general manager of the Bank for International Settlements.

Swaps advocates dismiss such concerns. They note that most of the money moving through swaps is in the payments they generate, not the face value of the contracts themselves. By that measure, all the swaps outstanding worldwide might be worth something like $250 billion. While that's hardly trivial, it's relatively small compared with the $700 billion traded every day on the world's currency markets. Proponents also argue that swaps' risks pale beside their abundant rewards. "Swaps perform a valuable function," says Richard L. Sandor, executive managing director at Kidder, Peabody & Co. "They allow a lot of people to manage interest-rate risks more effectively."

COMMON NEEDS. Indeed, swaps are, at their most basic, an elegant, simple, and cheap way of solving many financial hedging requirements for parties with opposite but complementary needs. Take a bank with lots of fixed-rate deposits and floating-rate mortgages. It fears its profits will plunge if yields decline. Another bank has lots of floating-rate deposits and fixed-rate loans. Its profits will be squeezed if money-market yields rise. From these banks' common need for protection, a swap is born.

With a bank or broker as the typical intermediary, the two institutions agree to exchange interest payments on, say, $1 million in mortgages for the next three years. In so doing, the bank with floating-rate mortgages will now receive a steady cash flow even if yields fall. If rates go up, the bank with fixed-rate mortgages will receive rising payments from its counterparty to cover its losses.

The banks could create similar hedges by purchasing Treasury futures or options every few months. But they might not want to go through the hassle and cost of constantly renewing the hedges for several years. On top of that, the banks might be obliged to classify such instruments as assets, forcing them to put into reserves scarce capital that might otherwise be used for loans. But swaps involve little or no principal and thus require very little capital to be set aside. "That helps stabilize our earnings," says Joram Fridman, who, as senior vice-president of National Westminster Bank USA, manages $6 billion in swaps. "Not using our balance sheet is a benefit."

While such plain-vanilla interest-rate swaps have long been the backbone of the market, they're no longer a bonanza to dealers. "In 1985, there were only 10 dealers who could give you a quote on a $100 million, five-year swap," recalls Edson V. Mitchell, senior managing director at Merrill Lynch & Co. "Now, you could easily get 100 bids." As a result, a typical swap involving payments on $100 million worth of loans may now yield a dealer as little as $20,000--one-tenth of what it would have brought during the mid-1980s.

To keep profits up, banks, brokers, and insurers have resorted to crafting ever-more-complicated and longer-term instruments. Take Hewlett-Packard Co. (table, page 102). It wanted to raise $100 million worth of Canadian dollars for three years. So, in April, it entered into a swap with Societe Generale Securities Corp., the New York investment-banking arm of the big French bank, that made use of bonds, Canadian and U.S. dollars, equities, and options.

The result was an "equity-linked" note. In lieu of interest, HP agreed to pay investors a return based on the price of its stock in April, 1995. But HP took on no equity-market risk. Behind the scenes and undisclosed to investors, SocGen agreed through a swap to assume HP's payment obligation to investors. In return, HP got a replica of the simple bond issue it wanted: It's paying SocGen interest on $100 million and will repay the principal at maturity. Industry sources figure the deal saved HP some $100,000 off what it would have paid on a conventional note issue.

INCOGNITO OPTIONS. More than anything else, the HP deal illustrates the blurring of lines between debt and equity as swap dealers grow more innovative. Structured as a note but designed to perform more like a package of HP stock and put and call options, the new instrument exists in a regulatory limbo never envisioned by Congress when it drafted the Securities Exchange Acts in the 1930s. In fact, HP's issue was marketed to fixed-income money managers who are required to stick to fixed-income investments but see more promise in equities, and to pension and mutual funds whose charters often prohibit them from owning options as too speculative.

The ability of swaps to leapfrog such artificial barriers is one reason equity-linked issues are now the swap market's fastest-growing products. But to some dealers, bonds offering an equity-market return are only the first step. In the past year or so, dealers have written as much as $1 trillion worth of even more complex equity swaps--instruments that diminish even further the distinction between stocks and bonds.

Let's say a British pension fund wants to buy $10 million worth of U.S. stocks but doesn't want to worry about fluctuations in the dollar's value. It could do a swap with Swiss Bank Corp.'s London office. At the end of every quarter, the fund would pay SBC the current interest rate on the sterling equivalent of $10 million. SBC would pay the fund the total return on that $10 million, invested in the S&P 500 and translated into pounds.

To hedge its risk and provide the promised S&P return, SBC might buy some or all of the stocks in the index, trade in futures, or do a little of each. Or SBC might attempt to match its obligation to the Briton against other swaps. The bank's New York office might do a swap with a U.S. customer who wants to pay SBC the total return on $10 million invested in the S&P and receive the return on a like amount invested in German stocks. So SBC would turn the American's S&P payments over to the British pension fund and then construct another hedge to offset its obligation on German stocks.

"Why not just do it the old way and buy stocks?" says Gary L. Gastineau, manager of equity-derivatives research for SBC. "To do so, the British fund would have to be able to trade and monitor what's going on in three markets--British fixed-income, U.S. equities, and foreign exchange. There are relatively few institutions that have that capacity."

WINDING ROAD. The complexity of swap deals is growing exponentially. Not long ago, one complex aircraft-finance deal involved 240 swaps before it was balanced out. "We look for the perfect hedge," says Morgan's Hancock. "That might take months, years, or more."

Hancock adds that he typically will hedge much of the risk on a swap immediately after it closes. Nonetheless, the lengthy chains of deals that swaps engender worry some critics. They fear that if just one transaction comes unstuck, payments among dozens or hundreds of counterparties could be suddenly disrupted. "When you have all these funny instruments flying around, you have no idea what the real exposure is," observes Henry T.C. Hu, associate dean of the University of Texas Law School and a critic of financial regulation.

Many regulators are trying to address this issue. The European Community is working on drafting tough new disclosure rules for swaps and other large exposures. By summer, the International Organization of Securities Commissions and the Bank for International Settlements are expected to issue their first set of common capital standards for banks and brokers engaging in swaps and other derivatives. In 1993, the Financial Accounting Standards Board will force U.S. swappers to more fully disclose unrealized gains or losses.

With regulatory pressure mounting and bank credit ratings falling as real-estate woes continue to mount, many swappers are growing more cautious. Increasingly aware that a swap that owes you money is no different than a loan, swappers are starting to demand that some counterparties put up collateral against balances due. Some are also restricting their business to such highly rated banks as Morgan, Bankers Trust, and Union Bank of Switzerland. To keep up, Merrill Lynch and Goldman, Sachs & Co. have recently put $300 million apiece into freestanding swap shops--units with their own AAA-rated balance sheets. Industry sources say Lehman Brothers is considering a similar move.

Fuller disclosure and more attention to credit risk and capital may slow the swappers. To many regulators, that's just fine. Even if Olympia & York's problems have little impact, regulators and bankers now realize they must fortify the globe-girdling swaps market against far larger threats that may lie down the road.

      Hewlett-Packard wanted to raise $100 million worth of Canadian dollars for 
      three years and pay a floating interest rate. By doing a swap in April with 
      Societe Generale Securities, its underwriter, HP was able to save about $100,000
      HOW THE SWAP WORKED Both parties exchanged payment obligations. SocGen marketed 
      an equity-linked, zero-coupon note giving investors a return that depends on 
      the future performance of HP stock. At maturity, investors will get between $90 
      and $143.60 for each $100 invested. SocGen executed the swap by covering HP's 
      payment obligation to note investors. It will send HP the payment, which HP 
      will pass on to investors. In return, HP pays SocGen a floating interest rate 
      on $100 million in Canadian dollars. When the note matures, HP will repay the 
      Canadian funds it borrowed to SocGen
      HOW BOTH SIDES BENEFITED HP pays an interest rate to SocGen that is about a 
      tenth of a percentage point less than it would have had to pay on a regular 
      floating-rate issue. And it avoided the risk of making payments to investors 
      based on HP's stock performance. SocGen, in turn, hopes to earn enough through 
      underwriting fees and trading in HP stock and options to compensate itself for 
      the lower interest from HP and the risk related to the price of HP's stock
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