Derivatives and the Danger Myth

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(Corrects notional amount of interest-rate swaps in second paragraph.)

July 16 (Bloomberg) -- There is a myth that derivatives trading is more dangerous than bank lending. For the most part, these products are benign. Mostly they allow people to recreate the same risks they would take by lending money without actually extending credit. Derivatives can, however, create problems insofar as they let financial firms increase leverage more than they otherwise should. But what matters in all cases is capital and short-term funding.

The most common type of derivative is the interest-rate swap. According to the Bank for International Settlements, the total notional value of all interest-rate swaps in the world is about $370 trillion. These products are designed to let borrowers who pay floating interest rates lock in a fixed rate, and vice versa.

Many traders use interest-rate swaps to gain exposure to instruments that perform like government bonds without actually having to buy and hold them. During the crisis, interest rates and equity prices both plunged, which opened a yawning gap between the value of pension assets and pension liabilities. To fill the void, many pension funds loaded up on 30-year swaps rather than buy physical bonds. That's one reason the interest rate on those instruments was lower than the interest rate paid by the U.S. Treasury until two weeks ago.

You might think that the sheer size of the interest-rate swaps market is bound to cause problems, but, notwithstanding some unfortunate municipal borrowers and a certain university's endowment, interest-rate swaps haven't caused much harm to the financial system. When Lehman Brothers Holdings Inc. went bankrupt it defaulted on a portfolio of about $9 trillion worth of interest-rate swaps. Many of these offset each other, however. Plus, Lehman had posted margin collateral when it cleared these swaps with LCH.Clearnet.

Credit-default swaps, which resemble insurance policies for bonds, are even scarier to those who aren't familiar with how they work. The market for these instruments is about a 20th the size of interest-rate swaps, or about $25 trillion at the end of 2012, according to the BIS. Unlike interest-rate swaps, these were associated with the failure of a major financial firm during the crisis: American International Group Inc.

The problems there weren't caused by anything unique to CDSs, however. Rather, AIG was too leveraged and vulnerable to a squeeze in short-term funding. AIG had unwisely given its counterparties the right to increase the amount of collateral they demanded. As the mortgage market deteriorated, the companies that had bought subprime CDSs from AIG demanded more collateral than the firm had available. This was essentially the same thing as a bank run, and it could have been prevented with the same tools used to prevent those horrible events: more equity and more stable sources of funding.

Remember, traditional lending can be just as dangerous as selling CDSs. Suppose I lend you $96 with the expectation that you will pay me $100 back in 12 months. That's risky for me. For one, you might not pay me back for any number of reasons. Plus, inflation might reduce the real value of the money you use to repay me.

After discounting these risks, I'm left wondering how much I can afford to lose. Big U.S. banks generally fund no more than 5 percent of their loans from shareholder equity and the other 95 percent by borrowing; they can't afford to lose more than about 5 percent of the value of their total portfolios if they want to stay solvent. In practice, death usually comes when short-term creditors start getting worried that they will have to endure losses that ought to be borne by shareholders and employees. How is this safer than dealing in interest-rate swaps?

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)