Investment bankers, swaps......and Ulcer!

So the Greek government has been revealed to be using swaps to disguise its debt. What else is new? It seems that there is no limit to the convolutions and disguises that can be made possible by using swaps.

Want to borrow more but don’t want to show on your books just how much you might be liable for in the future? Why not raise an amount with a swap arrangement, such that the liability you record on your books does not correspond to the actual servicing you have to pay? Want to improve your profitability ‘optics’? Why not do a swap where you can record upfront gains while hiding any future premiums that may have been created. Want to get into an investment not legally allowed for your institution? Why not buy the legally allowed one, and swap the returns (and the risks) with what you had wanted all along? The list of uses goes on.

When investment bankers talk about the benefits of derivatives, they talk about its function in managing risks for companies and investors. They talk about its ability to shift risk from those who don’t, or can’t take risk, to those willing and able to bear it. What they don’t talk about is just what types of companies, investors and entities, in real life, are the best clients for such products.

No, it’s not investors trying to manage risks. The best way to manage risk is to avoid positions whose possible risks can kill the organization. No, the best clients for derivatives are those who want to use it hide their existing risks, to convolute their end investors. The best client s are those who want to take on MORE risk, without seeming like they are doing so. They are those who want to seem like they are going by the book, when in fact they are betting the farm.

Swaps seem to be the most versatile product of them all for people with this kind of need. And investment banks have been hawking swaps to willing (and knowing ) clients all these years. For swaps enable client issuers to push issues with what I would call ULCER – Undisclosed Liabilities Contingent on Expected Risk – onto other investors.

Contingent risks are a normal staple of any investing. You cannot get into any business, or buy into any investment product with reasonable return, without avoiding a corresponding risk. When an investor enters into a transaction, there are contingent risks, and there any number of scenarios where they can expect to realize the risk.

The problem here is the undisclosed liabilities part. The swap enables issuers to sell instruments that hide the risk. Because the risk is coming from an asset or liability that is not recorded on the issuer’s balance sheet, no disclosure is made of this contingent risk (unless it is audited by a conscientious auditor who insists on mentioning it in the footnotes) The liability risk only gets disclosed if the time comes when subsequent events make the risk to become more evident, and expected.

It is difficult to swallow that companies (and governments) would unknowingly get into these kinds of swap arrangements without fully understanding the risks. For one, they know that they are getting the twisted benefits. In Greece’s case, they were able to raise more debt than they recorded. Because of the swap, the end buyers of that debt, and any subsequent debts, never knew that they were being fed an issue with ULCER.

When a company reports healthy profits in the current period, which mainly come from one-time mark-to-market gains on a swap where future streams may end up being contingent liabilities of the company, you can say that the company’s shareholders are being fed an issue with ULCER.

And when an insurance firm’s investment manager, aided by a swap, buys a fluctuating rate instrument denominated in a speculative currency not allowed buy its investment guidelines, its subscribers and investors and being fed ULCER.

But what can you expect of investment bankers who continue to hawk deal after deal of this sort? After all, most of their biggest clients now have numerous alternatives for raising capital, or can directly fund their projects themselves using internally-generated funds. The only way they stay relevant is by allowing themselves to be the intermediary which allows their clients to hide risk from potential and existing investors. So they pimp more swaps to more clients. And these swaps are now the main reason there is so much ULCER in the financial system, and everyone is getting sick digesting all its toxic acid.