Innovative Financial Derivatives

Complicated financial products have not seen their demise, despite the amount of federal regulation that occurred after the recent financial crisis.  Total-return swaps are the latest swap derivative taking the market by storm and causing some people to question the risk of these assets. Total-return swaps are a bit complicated, so let me explain this more simply.

Total-return swaps explained

Let’s say a bank and an investor engage in a total-return swap agreement. Total-return index swaps usually set the “reference” asset, or the asset they are benchmarking to, to be mortgage-backed securities, bank debt, sovereign debt, loans, equities, commodities etc. A bank is guaranteed to get payments throughout the life of the derivative. (A derivative is an asset that derives its value from the performance of an underlying security, entity, loan etc.) An investor gets a % of the total return of an index when the swap derivative contract expires. If this index makes less than what the contract states, the bank gets paid again for this “depreciation” in value. If the index makes more money than what the contract states, the investor makes money.  Essentially, the investor enjoys the cash flow benefits of a total-return swap derivative, without actually owning it. The investor only loses if this security declines in value. In order to “borrow” the security, the investor makes payments to the bank during the time of the contract. This payment is known as a floating rate payment or financing cost. Typically, the floating rate payments that hedge funds, or any investor, makes is a spread in LIBOR. LIBOR is the average interest rate that the average bank will pay if borrowing from other banks. This rate is calculated by London books and is similar to our federal funds rate. Many mortgage interest rates and financial products set their rate according to the LIBOR rate.

This seems complicated, who does this?

Total-return swaps are off-balance sheet transactions for the investor and balance sheet transactions for a bank. Off-balance sheet financing is used to report expenses (like the rental expense for holding this asset temporarily), whereas a balance-sheet will show whether an asset is capitalized (whether the asset was “leased” out). Hedge funds usually engage in total-return swap derivatives, because little money is due up front (and only a small amount of collateral is asked for). Collateral is any asset that a bank can take if an investor does not pay the agreed amount of the loan back.  Total-return swaps allow hedge funds to gain leverage. Leverage can mean that an investor uses borrowed capital to increase the return of an investment or finance their assets more with debt. Either way, leverage can intensify an investor’s gain AND losses. The high potential for upside is what draws hedge fund managers to buy these swaps.

Who bears the risk?

The investor does not legally own the index that the total-return index swap is benchmarked to. The investor has a long position in the market risk and credit risk of the asset. At the expiration of the swap, the investor can choose to buy the asset at the market price from the bank. The legal owner of the asset is a bank and this asset appears on their balance sheet.  The legal owner has a short position in market risk and in credit risk. A long position in an asset means that the holder of this position benefits if the asset goes up. A short position in an asset means the holder of this position benefits if the asset goes down.  If the underlying asset goes into default (say the asset is benchmarked to mortgage-backed securities and they all go into default) then the investor must pay the bank the difference in value from the initial price to the price after the asset defaults.

Total-return swaps today

For example, a total-return swap derivative from JPMorgan Chase is tied to the total-return of the Markit’s iBoxx USD Liquid Leverage Loan index.  Total-return swaps are not new, yet tying them to certain underlying indices, like Markit’s, is new and starting to cause an alarm. The alarm is sounding, because these derivatives are structured like collateralized debt obligations—the financial derivatives that tied risky housing loans into securities that brought about the financial crisis. Without a simplifying explanation like the one I provided above, reading a news article like the one found here from Bloomberg can be confusing for a general audience. Unlike the financial crisis, these new derivatives put a lot more of the risk on the buyer rather than the seller, which makes them less like CDO’s.

As mentioned in the Bloomberg article, these products do not come out of thin air. Investors, in the face of higher federal regulations and interest rates kept arbitrarily low by the Federal Reserve, are finding new ways to make money. With interest rates continuing to be so low, expect more financial innovation to occur.

In the words of Peter Tchir, of Brean Capital LLC:

‘‘We are moving into a phase where there will be more esoteric products. It does start setting up more problems for the future.’’

These problems, in my opinion, will all involve understanding the risk of new financial products. Total-return swaps turn the risk around to the buyer, which mean that if things get out of hand–a financial crisis, or problem, will start from the demand-side rather than the supply-side of finance.

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