Reasoned Government Regulation of Derivatives Needed
An enormous new financial business that could trouble even the Federal Reserve Board and yet defies the understanding of the nation’s best financial minds is terrifying governments around the world while also earning billions of dollars for the United States.
It is a business--called derivatives because it deals in new securities and agreements derived from underlying stocks, bonds and commodities--that can be said to help finance Medicare and keep your mortgage rate reasonable, while offering opportunity for your mutual fund.
It is also a business that deals in an incredible $15 trillion worth of securities, loans and interest rate swaps, putting a total of $600 billion at risk.
Those numbers frighten most people, including lawmakers in Washington who would regulate derivatives if only they could get a grip on what they are.
On the other hand, Susan M. Phillips, a governor of the Federal Reserve Board, sees the growth of derivatives as part of the evolution of financial risk management that began with the deregulation of interest rates in the 1970s and moved on to the mortgage-backed securities that helped save home mortgages in the 1980s.
To Phillips, an economist who has served as a commissioner of the Commodity Futures Trading Commission, interest rate and currency swaps are the latest examples of the know-how that keeps U.S. firms on the cutting edge of global finance and earns the United States a tidy surplus in international trade in services.
In their simplest form, derivatives enable a small business that can borrow only short-term at fluctuating interest rates--which expose it to the risk of rates moving up--to trade its interest payment schedule with a large business that has long-term loans at fixed rates but wants the lower, short rates because it can withstand the risk of fluctuation.
Typically, through a swap contract drawn up by a commercial bank or investment company, the small business pays the big fellow’s fixed rate of interest, and the large firm, which in effect has refinanced its debt, pays the lower, short-term rates.
The banks and finance houses, which verify the credit-worthiness of both parties and work out the actuarial risks of the swap transaction, make big money as intermediaries. Goldman Sachs, the Wall Street investment bank that is a leader in derivatives, has just reported a profit increase of 82% to $2.7 billion for 1993; Citicorp, the big bank that only two years ago was a candidate for Federal Reserve rescue, recently reported a ’93 profit of $2.2 billion.
But there are risks. Developing countries, such as Malaysia, Peru, Zimbabwe or Vietnam, which never qualified for much long-term credit before, are now able to get financing for their industries, because global big companies and sophisticated investors are buying their interest rate payments, just as they do for small businesses back home.
Getting credit is a boon for development and for U.S. and global companies that gain new and emerging markets.
But perhaps the country that never qualified before should not get so much credit now. There are risks of defaults--which could hurt the emerging markets mutual funds now so popular with Americans.
There are other risks too. Big companies and global investors often “buy more interest rate swaps than they have debt,” as one banker puts it, meaning they borrow money to bet on the direction of interest rates. That’s like an investor in stocks buying on margin or a real estate investor borrowing against one condominium to buy another.
If rates go against them, the losses are sudden and severe. That’s what happened last month in Europe. U.S. hedge funds--private funds that invest millions for sophisticated investors--had bet that German, French and Italian interest rates would continue to go down. When markets went against them, the hedge funds had to sell in a hurry, unsettling government debt markets and causing European governments to call for regulation of hedge funds and derivatives.
Calls for regulation are being echoed in the United States, where there are fears that a big bank or finance house will get in trouble and need a rescue from the Federal Reserve, disrupting the economy. Rep. James Leach (R-Iowa) is proposing a Federal Derivatives Commission to oversee the business.
As to what form regulation might take, more disclosure of transactions would be very useful, says Paul Isaac, chief economist of New York’s Mabon Securities and an expert in derivatives. Derivative transactions are now not reported in income statements or balance sheets and thus can produce spectacular mistakes.
Gibson Greetings last week found it was inadvertently at risk for $24 million trying to hedge interest rates on only $70 million of debt. Metallgesellschaft, the German mining and metals giant, lost $1 billion trying to hedge interest rates and oil prices.
But before regulation is written, we should look to the savings and loan crisis for perspective, says Mark Grinblatt, professor of finance at UCLA. In the inflationary 1970s, the S&Ls; were stuck holding long-term mortgages at low interest rates just when they had to pay out higher rates to keep deposits. Had the thrifts then been able to swap interest rates--or to sell their mortgages to the Government National Mortgage Assn., as they could in the 1980s--there might have been no S&L; crisis.
We might also consider that interest rate swaps have come into being with the oceans of government debt being issued here and abroad--reflecting the growth of government spending that we see in programs such as Medicare or F-22 jet fighters.
Institutional investors buying that debt want to protect themselves from interest rate fluctuation, and from the risk that the government will inflate the economy, eroding the value of its bonds, explains economist Albert Wojnilower of First Boston.
So markets in derivatives will continue to grow and develop. “There will be losses and bankruptcies, but perhaps not as many as without these tools,” says Patricia Klink, president of Advisers Capital Management, an investment firm.
She and Fed Gov. Phillips have a point: The new interest rate devices are not really risky in themselves. They’re tools that can bring benefit, or they can be abused. That’s why intelligent regulation is needed--not to stifle the market but to nurture it.
