Swapping uncertainty

“We, the G20 Finance Ministers and Central Bank Governors, reaffirmed our commitment to strengthen the financial system to prevent the build-up of excessive risk and future crises and support sustainable growth.”  From the communiqué issued this weekend.

In finance, the financial system is the system that allows the transfer of money between savers and borrowers”.  Wikipedia

But the financial system being strengthened is  no longer just a system that “that allows the transfer of money between savers and borrowers”

It is now also a system in which banks rely upon creating derivative instruments to maintain substantial profitability. The “transfer of money between savers and borrowers”, does not depend upon the existence of derivative intruments and other complexities for its execution. Money has been transferred efficiently between savers and borrowers for centuries without the intermediation of recent innovative fee absorbing structures, which are more akin to a new tax on the transfer of money.

A typical example is an interest rate hedge, the manifest purpose of which is to allow one party to hedge i.e. to insure against a damaging change in interest rates over a defined period. A property investment company buying a property yielding 8 % with a variable interest rate loan commencing at 5% might decide to lock into the 3% differential by purchasing a derivative contract should interest rates increase to say, 9%. It would do this if it thought interest rates were more likely to increase than decline over the period.

In recent years, many finance directors of quoted companies have taken a view, i.e. decided they have a better idea than the market,  of the movement in future interest rates and hedged the interest rates on their borrowings accordingly.  Most property companies which took out interest rate swaps did so to protect themselves from what was  perceived to be the risk of interest rates rising in the future.

A call on interest rates, is a call on interest rates. You can’t hedge yourself out of the financial pain of being wrong by taking out an interest rate hedge, because taking out a hedge is taking a position on future interest rates, which are unpredictable.

Now because their guesses were wrong  (instead of increasing, interest rates declined to the lowest levels in decades), huge liabilities have been created in the balance sheet of these property companies, in some cases sufficient to threaten their solvency or independence. An examination of the latest balance sheet from Brixton plc (BXTN) will show what can happen!

It isn’t quite a zero sum game though, for the creators of the hedges, it is a money spinner whether the roulette ball falls on red or black.

Is this the financial system G20 wish to strengthen?