May 17, 2013

Dear Governments, You Can Not Speculhedge™!



It shouldn't sound new to financial insiders what's been happening in the last year or so. Several Portuguese, Italian and British government institutions, public-owned companies and city councils have sued investment banks for allegedly mis-selling toxic derivatives products (see here, here and here). The contracts at the center of the scandal are interest rate swaps. I already covered in details what an interest rate swap is about and its applications in different contexts (see here and here) and would like to focus on the specific implications of the cases which have seen governments as a counterparty. 

Let's analyze what the three cases have in common. In each of them, governments entered interest rate swaps to reduce interest rate exposure. In the Portuguese case, public companies entered several derivatives contracts since 2003. Their goal was to hedge against potential increases in the benchmark Euribor. Between 2001 and 2008, the city council of Milan (Italy), along with 524 Italian government institutions, entered over 1,000 interest rate swaps for a notional amount of €35 billion. In the UK, Barclays, HSBC, Royal Bank of Scotland and Lloyds sold over 40,000 derivatives to small businesses since 2001. In each of the three cases, government-owned companies and small businesses incurred substantial losses and sued investment banks. In the last two, courts forced investment banks to pay customers compensations as they said "banks mis-sold products to customers", adding that "customers were not fully aware of the risks" .

Details about the Portuguese deal have not been revealed yet as the contracts are still in place and the two parties may be hurt if markets knew what the contracts are about. However, we can assume that the derivatives products were not aimed at hedging but speculating for two specific reasons: Maria Luis Albuquerque, the Portuguese secretary of state for treasury and finance, "described the country’s hedging contracts as “toxic” with “elevated risks" adding that "some contracts had interest rates that were well above 20 per cent". According to the standard definition of hedging "an hedge is equivalent to "making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract" (from investopedia).  There is not such a thing as a toxic hedge with elevated risks. Hedging should bring the risk associated with the original position relatively close to zero. Also, it seems like there may be a structured component in the Portuguese swaps as the downside risk of a loss seems to be disproportional to the upside

Why are these cases so relevant for the public? Public finances can be negatively affected by the losses with potential disastrous consequences for a country's economic efforts to keep up with fiscal adjustments (see Italy) and/or stay on track with bailout programs (see Portugal). 

It's important to note that governments and small businesses seem to have unconsciously behaved as 'profit centers' (as the contracts they entered are speculative by nature), with the potential negative consequences mentioned above. A lack of general understanding of risk is evident. Transparency has to improve in order to make transactions safer and reduce counterparty and systemic risk. 

FOLLOW @DvegaDtime ON TWITTER

2 comments:

  1. Local autorities shouldn't be allowed to trade any derivatives at all and "hedging" should be managed at central level. There is just an enormous lack of incentive from all sides to do so...

    ReplyDelete
  2. In a strict sense I understand and generally agree with your assertion that a true hedge reduces risk and is not, therefore, toxic. However, most hedges require dynamic management as positions and market conditions evolve. The operational demands associated with this management are often greatly underestimated. A collection of option positions may be constructed to hedge out downside risk but maintaining them is far from a simple matter and never matches the continuous world of SDEs.

    Another issue is that a hedge is based on a theoretical model which never quite matches reality. Ask any stat arb manager! Thus, a hedge that deludes one into thinking that risk has been taken away may lead one into dangerous levels of leverage. This, in fact, interacts with the firs effect as the inevitable compromises in dynamic management and their associated exposures are further multipled.

    In a practical sense, then, it is possible to have "toxic hedges with high risk levels" even when those hedges are designed to reduce risk.

    ReplyDelete