From the UK to Italy, an interest rate derivatives headache
My story (with Elisa Martinuzzi) about Italy admitting it paid Morgan Stanley billions to unwind derivatives, and the Telegraph’s superb reporting on the alleged mis-selling of derivatives by banks like Barclays to small British companies, have something in common.
Small British companies and Italy share an environment where both of them are finding it hard to access credit and roll over funding. You’d think the emergency measures by central banks to keep borrowing costs low (by purchasing government bonds or helping banks to do so on their behalf) would make things easier. Unfortunately, the benefits are being counteracted by the impact of derivatives that these borrowers purchased before the crisis, when bond yields were higher.
Put yourself in the shoes of a borrower in the years before 2007, when government bond yields were around four or five percent. In the case of Italy, you could borrow freely for periods of five or ten years – to the tune of trillions of euros. Officials at Italy’s treasury wanted to lower the repayment costs, and investment bankers offered them derivatives – swaps and options – that spread the costs over a much longer period, say 30 years. It turns out that Italy bought 160 billion euros of these things.
Small UK companies were dependent on banks for long-term loans, and the banks pushed them into buying derivatives that fixed their loan rates for 30 years or more. Like Italy, the derivatives often lasted much longer than the underlying loan.
In both instances, it took two unanticipated events happening simultaneously to turn this into a problem. On one hand, the financial crisis reduced access to funding, pushed banks to recognise their counterparty exposure on derivatives, and forced borrowers to tighten their belts with austerity measures. Meanwhile, the emergency measures by central banks caused euro and sterling swap rates (which respectively track German and UK government bond yields) to plunge. That made derivatives where banks received long-term fixed payments incredibly valuable.
Things came to a head in two ways. The UK companies had been required by the banks to enter into mark-to-market collateral agreements on their swaps. As the derivatives moved in their favour, the banks were able to immediately demand collateral, draining the companies of cash. Italy was luckier because it didn’t have to post collateral. Instead, the problem involved options or forward-starting derivatives that were reaching maturity and kicking in, increasing Italy’s borrowing costs at the worst possible time.
In Daniel Kahneman’s book ‘Thinking Fast and Slow’ (which I will be reviewing shortly) there is a section on what he calls ‘hindsight bias’: after some disaster has happened, peoples’ recollections of the probability they ascribed to it are much higher than their actual beliefs at the time. Kahneman is irked by pundits who claim that they ‘knew’ the financial crisis was ‘inevitable’.
Kahneman would rightly say that no-one knew with certainty five years ago that the interest rate derivatives bought by Italy and small UK companies would cause such trouble today. However, a better question to ask might be what probability the markets gave five years ago to the scenario that bond yields and swap rates would fall to today’s levels.
While credit default swap markets ascribed minute probabilities before 2007 to the subprime and Greek defaults that would eventually come to pass, interest rate derivatives markets priced in much higher likelihoods of a low rate world. This was driven by demand – as early as 2003, insurance companies and pension funds were worrying about how low bond yields would affect the cost of their fixed liabilities.
In 2006, I reported that Munich Re bought 12.5 billion euros of receiver swaptions (options on swaps) from Morgan Stanley for this purpose, at the same time that Italy was selling them. A few UK pension funds, such as WH Smith, First Group and HSBC, were also active at this time, contracting to receive long-dated fixed payments on swaps at the same time as small UK companies were being steered onto the other side of such positions.
In the case of Italy’s treasury, there can be no excuse for not understanding the risk of low rates when they were effectively betting with Italian taxpayers’ money. By contrast, small UK companies cannot be labeled as ‘sophisticated’, and may not have understood what they were getting into.
What Italy and the small UK companies do have in common when it comes to derivatives is a problem of secrecy. Having seen the role that derivatives played in Greece’s problems, I’ve been pushing for a while for the Italian treasury to come clean on its derivatives exposures. Fortunately, our story on Friday seems to have had an impact. In the UK, it’s a scandal that Barclays prevented its clients even from talking to the Financial Services Authority about swap contracts.
Perhaps that’s the most important lesson: secrecy breeds muppets.