Think Twice Finance

The Subprime Mortgage Crisis, Part 4: Over-the-Counter Derivatives Become a Market.

If one actually does begin the afterlife with a conversation with St. Peter, I know the first topic of conversation in my case will be plain vanilla swaps. I was one of the first bankers to open an arbitrage book trading plain vanilla swaps against futures. This was an analytically challenging exercise and ultimately quite a financially successful one. The business has grown to enormous proportions. Interest rate swap portfolio sizes of the large banks are now well over 20 times the size of their loan portfolios.

The thing is, then and now, I am ambivalent about the role of the interest rate swap in finance. We introduced the arbitrage to cross the barrier raised by the regulators refusal to permit the appropriate accounting for futures by banks (see Part 3.) Having opened a futures brokerage to market futures to the regional banks, we were stymied by the accounting rules. Futures could not be accounted for in the same way as the balance sheet risks they were protecting by hedging banks, leading to volatility in reported earnings that stockholders rejected.

Interest rate swaps, on the other hand, could either be accounted for as a hedge or marketed to market in a trading portfolio. Voila, I said to myself. Since interest rate swaps were to me simply extremely clumsy futures contracts, I could open an arbitrage book, sell swaps to hedging banks, then hedge my side of the swap with futures contracts and mark both sides to market.

Seen at that level, I had no problem with the plan. The regulators had forced poor accounting rules on the banking system, preventing them from prudently protecting themselves from interest rate risk. The arbitrage provided the banks with the hedge they needed at a profit to my institution.

But looking a little further under that surface, there were real problems with interest rate swaps. While what did appear on the accounts of banks at the time looked fine, what did not appear on the accounts was not so fine. What did not appear was the fact that swaps may be accounted for as deferred income or expense because the payment of the revenues associated with swaps is actually made well after the market value of the swap changes. This gives rise to a credit risk that is not associated with futures.

So therein lies the deal I made with the devil. Futures were a less risky hedge than swaps. But poor accounting for futures obviated their use. Swaps could be used to reduce the risk as well as futures, with no associated accounting side-effect. But there was an associated adverse real effect. They increased credit risk within the system gratuitously in a way futures did not. It was a small increase in risk. A small percentage of the risk the banks hedged away, but a devilishly difficult risk to estimate and provide capital adequate to support. Watching the volume of trade in interest rate swaps balloon over time has done nothing to assuage my guilt. Nor has the introduction of credit swaps, which I fear further deepen the opportunity for less skillful institutions to misjudge or mis-report the credit risks they have assumed. The next log takes up credit swaps and off-balance sheet reporting more generally, as we follow along the garden path that ultimately leads to the subprime mortgage crisis.