Monday, February 25, 2008

Adventures in Swapland

(Felix Salmon) The Economist reports on something known as a "CMS spread ladder swap," which apparently was reasonably popular among German municipalities before it blew up. They were paying a relatively high fixed interest rate on their debt, and Deutsche Bank helpfully stepped in to swap that into a lower floating interest rate. Except in this case the rate was so much lower, it seems, that it fell through zero and the municipalities actually wound up receiving interest payments on their own debt:

Local governments felt they were paying too much in fixed interest payments as euro interest rates were falling. Deutsche offered to swap the fixed rates for floating, and based the level of these on the difference between two interest rates--most commonly the two-year and ten-year swap rate.
So far so simple, but the actual floating rate was set by a mind-bogglingly complex formula: the interest-rate spread was subtracted from an arbitrary figure, doubled or trebled, and added cumulatively to the rate paid in the previous period. If the gamble went well, municipalities could theoretically make a return of 10% or so on the nominal amount.

I'm all in favor of financial innovation, but this is crazy. If I'm a debtor, I expect to have to make interest payments on the money that I owe. If a salesman from Deutsche Bank comes up to me and offers me a deal where I can make a 10% profit on my debts, I'm going to smell all manner of rats.

Now I might be wrong about this, the article is a little bit unclear. Yes, it does say that "governments felt they were paying too much" on their debts, but it also talks about one such government, the city of Hagen, losing €57m "on a nominal investment of €170m".

Even if these swaps were credit instruments, however, where the municipalities received a floating interest rate on their cash, there's no way a local government should ever enter into a swap where that floating interest rate turns negative. That seems to be what happened here: "clients by the end of a five or seven-year deal could be paying as much as 25% to the banks," says the magazine.

At this point it's worth remembering the words of Andrew Clavell, on the situation which obtains any time an investment banker is selling a product to a client:

You don't know. Really, you don't. Hang on, I hear you shouting that you're actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don't. Know.

(Also via Alea, who is rapidly becoming for deriviatives what Calculated Risk is for housing.)

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