Interest rate swaps not for beginners

AIR PRODUCTS & Chemicals of Allentown, Pennsylvania, is the latest casualty in the derivatives game.

Like a junkie supporting an expensive habit, this respected old-line manufacturing company suddenly got in over its head as a result of five interest-rate swaps contracts purchased from Bankers Trust. Following the Fed's latest interest-rate squeeze, the company's payments shot up overnight. The result was a pre-tax loss of dollars 96.4m. Air Products thus followed Procter & Gamble, Gibson Greetings, Mead Corporation and Marion Merrell Dow to become the fifth Pennsylvania victim of the Bankers Trust derivatives programme.

These corporate tales of woe are fuelling fears in the US Congress that the dollars 14,000bn derivatives market poses new risks to the global financial system. Congressman Edward Markey, chairman of the House of Representatives finance subcommittee that oversees US securities laws, indicated last week that he would introduce legislation to regulate derivatives more broadly.

This, despite the testimony of three of Wall Street's most respected experts - Sir Dennis Weatherstone of JP Morgan, Gerald Corrigan, former chairman of the New York Federal Reserve Bank, and Richard Breedon, former chairman of the Securities & Exchange Commission - that new restrictions are unnecessary since the industry is working hard to control risks.

The almost daily litany of losses related to hedge funds, currency swaps, emerging market bonds or a rainbow of other new products makes it difficult to feel sanguine about the soundness of the financial system. The realities of the 24-hour global trading market are only just beginning to settle in.

At a recent Washington conference, several participants observed that the 1990s are a replay of the 1930s in that so many individuals are holders of debt. This is in sharp contrast to the debt crisis of the 1980s, when large banks were the main debt holders, thus making the system slightly easier to control.

It is the proliferation of non-bank products held by large and small individual investors that is raising new concern over systemic risk. Unlike the more traditional distribution of credit by banks, these non-bank entities are not bound by capital and reserve requirements, limits on loans to single or related borrowers, or limits on transactions with parents and affiliates. As a result, finance companies, securities houses, insurance companies, mutual funds and the like are taking over many of the functions of banks.

The big question for policymakers is what happens to the system if a Goldman Sachs, a Prudential Insurance or a GE Capital folds? Is there enough of an early warning system in place to give the traditional lenders of last resort time to act? Or should there be a new set of international disciplines to regulate this 'parallel' banking system, which makes single-sector regulation look very obsolete?

Risks posed by derivatives are bringing matters to a head because of the first reports of very big losses. Also, both regulators and practitioners are beginning to realise how little they actually know about this 'computer whiz-kid' style of formula trading based on elaborate models. Hedging against or speculating on price movements in stocks, bonds, commodities, interest rates or currencies is no game for beginners.

As the chief financial officer of Air Products & Chemicals admitted last week: 'Our analysis simply did not detect the risks.' The company was attracted to the swaps as a means of lowering interest costs on dollars 1.8bn of loans and bonds. The object was to use the derivatives, in effect, to convert its fixed, high-interest rate obligations to lower but variable rates. In the beginning, when US interest rates dropped to historic lows, the strategy worked. But when the Fed moved to raise rates in February, 'all hell broke loose'.

Under terms of the swaps contracts, Air Products had to make dramatically higher payments to Bankers Trust. These were leveraged swaps, meaning that once rates rose above a threshold level, payments multiplied far faster than the underlying rise in rates. Additionally, Air Products was committed to the higher payments for three to nine years and only realised the bind it was in after Procter & Gamble reported a similar dollars 157m loss on derivatives.

Top company officials later explained that they had never intended to gamble on stable interest rates. The problem was simply that the managers in charge did not understand the risks. One official told the Washington Post: 'Our risk model relies on statistical probabilities. It rated the probability of interest rates rising to today's levels as very remote. We are now reviewing the model.'

If this is what happens to a sophisticated player, no wonder Congress is concerned about those less so.