Derivative Accomplishes Purpose And Unwinds At Market Price

You can read the Jamie Dimon “Don’t gloat about how bad Goldman is. Did you hear me? Don’t gloat about how BAD GOLDMAN IS. The fact that GOLDMAN is BAD is of no interest to our clients. Or the press. Don’t leak this to the press!” memo two ways. One is, y’know, what it sounds like: Dimon gets to score some easy/meta points by spreading it around that his business practices are so superior that he doesn’t even need to spread it around that his business practices are superior. The other is that making money off of clients isn’t something invented at Goldman Sachs and anyone at JPMorgan who throws stones is likely to be clonked on the forehead by a ricochet. (Or possibly by a deranged fictional whistleblower!*)

The latter interpretation is probably right for James Gorman’s more full-throated defense of Goldman because whoops:

When Morgan Stanley said in January it had cut its “net exposure” to Italy by $3.4 billion, it didn’t tell investors that the nation paid that entire amount to the bank to exit a bet on interest rates.

Italy, the second-most indebted nation in the European Union, paid the money to unwind derivative contracts from the 1990s that had backfired, said a person with direct knowledge of the Treasury’s payment. It was cheaper for Italy to cancel the transactions rather than to renew, said the person, who declined to be identified because the terms were private.

The cost, equal to half the amount to be raised by Italy’s sales tax increase this year, underscores the risk derivatives countries use to reduce borrowing costs and guard against swings in interest rates and currencies can sour and generate losses for taxpayers. Italy, with record debt of $2.5 trillion, has lost more than $31 billion on its derivatives at current market values, according to data compiled by the Bloomberg Brief Risk newsletter from regulatory filings.

“These losses demonstrate the speculative nature of these deals and the supremacy of finance over government,” said Italian senator Elio Lannutti, chairman of the consumer group Adusbef.

So, y’know, sure. Italy has €1.8 trillion of government debt; $31 billion at 1.31 EURUSD is 1.3% of that. Derivatives from the 1990s that backfired because rates went down … Just for fun, the lowest yield on German 10-years, let’s call that the risk-free rate, in the 1990s was 3.632% in January of 1999. Now it’s 2.05%. It’s kind of foolish to assume that Italy’s cost of borrowing attributable to “interest rates” (i.e. swap/Bund/risk-free rates), as opposed to “spread” (i.e. its own crap credit), has fallen by that amount. But let’s do it anyway!** If it were true, Italy’s borrowing costs attributable to interest rates would be down 1.6% a year since the 1990s – meaning that each year it saves more in interest expense than its entire derivative losses over the last two decades. In other words, if you grant my simplifying assumptions, if rates had stayed where they were when Italy entered these derivatives, it would have no loss on the derivatives but would be paying an extra $37 billion a year to a different cabal of evil financial-supremacy folks, specifically bondholders. And if rates had gone up, Italy would be paying even more to bondholders – but would be getting some of it back from the evil muppet-rapers at Morgan Stanley.

Two points on this. One is, did Morgan Stanley make, just, truckloads of money here? Well, Bloomberg again:

Morgan Stanley had a gain of about $600 million in the fourth quarter related to the unwinding of contracts with Italy. That gain was a reversal of charges it took earlier in the year to reflect the risk that the country wouldn’t pay the full amount it owed, Chief Financial Officer Ruth Porat said in a Jan. 19 interview.

The $600 million gain accounted for about half the bank’s fixed-income trading revenue in the fourth-quarter, excluding a charge related to a settlement with MBIA Inc. and accounting gains tied to the firm’s own credit spreads.

So, yes, truckloads of money in some sense. But that’s only because it lost truckloads of money – in an expected-value sense – earlier in the year when Italy looked like a bad credit. (As opposed to now, when it looks like … a … credit that Morgan Stanley is not exposed to.) It’s easy to blame a bank for baking hidden spreads into derivatives rather than just charging an honest fee, but the reality is that those spreads are “fees” only in an expected-value sense, and evaporate and then some if, for instance, you build in an insufficient cushion to account for the borrower’s creditworthiness or not-so-creditworthiness. Even if MS had perfectly hedged the interest rate risk in its Italy swaps, it probably wasn’t counting on its CVA to a big European sovereign borrower widening by $600mm. The fact that it got that money back is no doubt a relief, but it’s not a windfall profit.

The second thing is kind of more important, which is, shut up Italian senator Elio Lannutti, chairman of the consumer group Adusbef. This demonstrates the opposite of the speculative nature of these deals. These deals moved against Italy when rates moved in Italy’s favor. Italy lost on derivatives when it gained on the bond market. (And then lost more on the bond market by being a terrifying credit, but that is hardly Morgan Stanley’s fault.***) That’s what we in the derivatives trade like to call a “hedge.” And it worked. Italy is getting exactly what it paid for: a synthetic dampening of its interest-rate risk over a long period. Morgan Stanley’s long-retired 1990s swaps salespeople didn’t rip Italy’s face off: they built a product that offered Italy an attractive risk/reward proposition, and sold it to them. It just so happened that the risk, rather than the reward, was realized.

But lots of people think like the Adusbef guy, as evidenced by the fact that these stories keep being ooh-evil-Wall-Street news. If I were in the business of selling interest rate hedges to sovereigns (or municipalities!) I’d be building in fees to compensate me not only for my market and credit risk, but also my asymmetric**** if-this-trade-moves-against-the-issuer-their-senators-will-go-around-demanding-to-tear-it-up risk. But then, of course, I’d be accused of treating my clients like muppets.

Gorman Says He Told Staff Not to Circulate Op-Ed on Goldman [Bloomberg]
Italy Said to Pay Morgan Stanley $3.4 Billion [Bloomberg]

* I don’t want to spend a lot of time on the deranged fictional whistleblower but he does a good job of spinning standard comp expectations management as an EVIL PLOT TO MANIPULATE THE PRICE OF GOLD, which I suppose is proof that he is in fact a financial services employee.

** The math in the text is muppety but the baaaaasic idea is: these derivatives made Italy short more duration, because it lengthened their fixed obligations, which you can tell because (1) Bloomberg sort of describes it that way and (2) the marks went against them when rates went down. So you can sort of simplify this in your mind’s eye to Italy issued floating-rate debt (that floated every 5 years! staggered!) and swapped it to fixed (over 30 years!). Its cost of pseudo-floating debt (i.e. issuing new 5-years since 1990) has gone down, so it gets less on the floating leg but continues to pay on the fixed.

You can quibble with other things here, like just using the 10-year rather than the curve and assuming that spread is invariant to rates, but there’s also some cushion in the fact that I’m using the lowest German rate of the ’90s.

*** Really! Some people want it to be. But you could probably come up with reasons why it is bad to let issuers buy CDS on themselves from investment banks. Italy buying a swap from MS linked to Italian government bond rates is that. Issuers swap their interest rate, i.e. risk-free-ish rate, risk, and they expect their swaps to move when risk-free rates move. If their credit moves, that’s on them.

**** Because, if rates had gone the other way, somehow I doubt Morgan Stanley would be going to the press demanding to tear up their contract with Italy.

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24 Responses to “Derivative Accomplishes Purpose And Unwinds At Market Price”

  1. Guestest says:

    The bigger question being why did Italy have a record debt of $2.5 trillion.

  2. Rex R. says:

    no seriously, more footnotes

  3. Gor dickman says:

    We'd like to welcome Greg Smith to the firm.

  4. Crook in B-School says:

    So, how many US money hundo bills would fill a 80 ft box trailer to the roof, end to end, wall to wall, floor to ceiling?

  5. Wisconsin Gas Buyer says:

    So, there were some embedded options in that deal? Interesting.

  6. agreatdaytothink says:

    Matt. Serious question. Do the banks typically price floating-for-fixed swaps with a bias towards the theory that rates were likely to go down? And if so, was it because they expected the client to be more focused on rates going up, and would pay more, or because bank economists predicted rates would go down, or was it with the knowledge with the proliferation of strucutred products, that it would drive rates down no matter what the macro economic scenario.

    – Guy who got 13 out of 16 games right yesterday.

  7. Guest says:

    Hi Matt,
    You've had a long week. Why don't you knock off a bit early today and head over to Molly's Pub for a few and put it on the DB Plum Card. I'll handle the afternoon shift.

    Happy St. Patty's Day,

  8. Guest says:

    They're called footnotes, Matt, not legnotes.

  9. Guest1 says:

    Matt’s analysis is mostly correct… All this outrage over large unwind payments (I think there was similar brouhaha over Harvard unwinds) is silly. When Italy did these trades (either by paying in swaps outright or by selling receivers), they were designed to hedge duration. That is precisely what was achieved and I don’t remember any particular outrage when these particular deals were valued the other way, i.e. massively in favor of Italy (say in 2008, when rates were quite high). Italian credit has nothing to do with rates, as Matt points out, and it’s not Stanley’s fault that Italy’s spread over swaps blew out.

    However, one thing to note is that none of it means that Stanley didn’t treat the Tesoro as muppets. As far as I know, for purposes of gouging bid/offer, derivative trades with sovereigns, such as the Tesoro, were absolute windfalls for the banks on the way in; next only to how much the banks could make by trading with smaller public entities, such as municipalities. How much of this is the evil banksters’ fault is a meaningful question.

  10. Anna says:

    Listen Tolstoy, if the footnotes are longer than the book, just put them in the book…..

  11. Jim says:

    "Stop going for the easy buck and start producing something with your life. Create, instead of living off the buying and selling of others."

  12. Tom says:

    I just wonder how many Italian government officials sinvolved with buying these derivatives understood how they really work…or when they don't?

  13. smith73 says:

    poor taxpayers…we always take the full blow of how come some people play with our hard earned money… this fact is just too painful.