Swap Market Unnerved by Credit Risks
When Bankers Trust New York Corp. called a routine meeting with analysts to discuss its strong third-quarter results, it wound up raising some eyebrows instead.
Along with the good news, Bankers Trust executives had to confess that a single interest rate swap caused most of the $39 million addition to nonperforming assets.
The addition had little impact on the money-center bank's results - swaps and related activities generated the lion's share of $323 million in the bank's third-quarter trading revenues.
Nevertheless, it offered a rare glimpse of the risks that swaps increasingly entail. Bankers Trust's experience was emblematic of the growing importance of credit quality in the $3 trillion swap market.
Bankers Trust stumbled for a reason that could easily trip other banks battling for a share of the lucrative swaps business: The credit quality of its swap counterparty eroded.
"This was the year of the big credit scare," said Denise Boutross, executive vice president in charge of all day-to-day derivatives operations at DKB Credit Corp., a subsidiary of Dai-Ichi Kangyo Bank.
Contending with the demise of Executive Life Insurance, the Bank of New England, and Drexel Burnham Lambert has shown dealers throughout the market that exposures on swaps can be large.
So they are demanding greater assurances that swap contracts will reach maturity.
In this environment, demands for collateral are becoming increasingly common. Some dealers with less than stellar ratings are simply focusing on short-term, plain-vanilla contracts that are generally deemed less risky, because their would-be clients resist doing higher-risk business with them. Still other players have opted to create highly rated subsidiaries to undertake new business for them.
Concern over Ratings
"I think every participant out there is looking at how they can maintain or improve their credit," said Mark Wilkinson, a director at Salomon Brothers Inc.
Emphasis on creditworthiness is a plus for strong banks that will attract high-quality business. But for banks whose credit ratings have slipped, or are just in doubt, the change is less welcome. Whatever their role in these multiparty arrangements, they will have to bow out or settle for higher risks and less certain rewards.
"There are some counter-parties who just won't deal with anyone who isn't double-A or better" rated, said Leslie Rahl, president of Leslie Rahl Associates. "Others take a more price-oriented approach. Within the dealer community the trend is to differentiate pricing based on credit quality."
The use of swaps has spread like wildfire in the past decade. Measured by the notional principal amount on which the swap is based, volume skyrocketed 335%, to $2.9 billion, in the four years that ended last Dec. 31, according to the International Swap Dealers Association.
Citicorp Is Bullish
And business is still on the rise. Despite its dubious credit standing, even Citicorp is bullish. Deepak Rastogi, head of the bank's derivatives group, which encompasses swaps activity, said he expects that 1991 will be the best growth year ever for Citicorp.
Swaps are agreements between two companies to exchange cash flows, like fixed-rate and floating-rate interest payments. Typically, banks use swaps to protect themselves against shifts in interest rates or exchange rates. They make money on them as dealers by agreeing to swaps at different rates and capturing the spread.
Lately, the products available in the swap market have multiplied. In addition to interest rate and currency swaps, the market now includes hybrid products and contracts tied to a range of out-of-the-way indexes. And banks like developing these complex products because they can charge more for customized products than they can for run-of-the-mill interest rate swaps.
"I think you're moving away from the commodity sort of interest rate or foreign exchange swaps," said Richard Rogalski, George J. Records professor of investments at Dartmouth College's Amos Tuck School of Business Administration. "Now you're getting into very innovative combinations of swaps and futures contracts. That's where the real growth is."
Easy on Capital
The business is completely institutional - the average notional principal amount of a swap contract is $25 million - and enormously lucrative for banks because of the low level of capital that has to be set aside. Despite the third-quarter setback at Bankers Trust, for example, the return on equity is "significantly ahead" of the 20% minimum threshold the bank sets, according to Brian Walsh, head of the bank's international capital markets section.
Such a lucrative business has lured a lot of competitors with widely varied credit profiles. The International Swap Dealers Association now has 140 members, and most are banks. There were only 10 members in 1985.
A Typical Swap Arrangement
Plain-vanilla swaps normally involve two parties. For example, two parties to an interest rate swap agree to exchange interest payments based on some notional principal amount for a specified period of time. One party makes fixed-rate payments for the life of the contract, while the other party makes floating-rate payments.
In effect, interest rate swaps let users convert interest obligations to the form they prefer: Someone expecting interest rates to fall might agree to make floating-rate payments and receive fixed-rate payments, for example. A hypothetical example of the use of swaps is described on page 14.)
Banks and finance companies often use swaps to match their interest obligations with the interest they are receiving. "We use derivatives [such as swaps] primarily for interest rate risk management," said Garland Hagen, executive vice president of Crestar Bank. "They're great. They let you do all kinds of things. You can get the rates you want and the interest sensitivity you want, regardless of what the market wants."
And many strong banks that deal in swaps are able to maintain portfolios with very high quality counterparties - higher quality, in fact, than many of their corporate loan clients.
That's because large, highly rated companies are able to tap the capital markets themselves when they want to borrow money, leaving bank loans to lower-quality borrowers. But when they want to arrange long-term contracts to exchange payments, those same highly rated companies try to do business with high-quality banks.
"Swaps get written with big corporations and governments - better-quality names than many borrowers," said Mark Brickell, chairman of the International Swap Dealers Association. "This business increases the quality of the average credit risk bank shareholders are exposed to."
Meanwhile, however, regulators are starting to pay more attention to swaps. An international committee of bank regulators chaired by E. Gerald Corrigan, president of the Federal Reserve Bank of New York, is considering requiring banks to set aside capital against market risk and position risk - the risks of foreign exchange and securities trading. "The market risk associated with a portfolio of derivatives is not fully accounted for in the risk-based standards," said one regulator.
Credit rating agencies have also raised questions. Moody's Investors Service Inc., for one, issued a report last month detailing points to consider about derivatives. Among the negatives: "Poor controls, inadequate analysis, and weak counterparty creditworthiness - to name but a few problems."
Swap dealers are trying to deal with credit quality concerns in a variety of ways. Some are including collateral requirements in more of their contracts. Others simply demand collateral on more of their swap contracts. "We may get charged more than a [higher-quality regional]," said one regional banker who makes extensive use of swaps. He said his bank is being asked for collateral more often.
Still other dealers are combing portfolios, selling off and hedging swaps where credit quality is below tighter standards. In doing that, they are changing the face of the swap market.
James Healy, a managing director and cohead of the North American office of Credit Suisse Financial Products, said, "You will end up with a tiering situation where some people only want to do business with double-A and triple-A credits, and then you'll have the rest of the market."
Mr. Healy is not unhappy about this trend. His company is an offshoot of triple-A-rated Credit Suisse, and it stands to benefit from the shift in the market. But others, even from companies lacking top ratings, see the trend as well.
"It's definitely getting tougher for [banks with mediocre credit ratings]," said Brian Walsh of Bankers Trust. "They're going to have smaller credit limits, and people are going to want to do shorter-term deals with them."
Single-A-rated Merrill Lynch & Co. last month created a new subsidiary, Merrill Lynch Derivative Products.
Accommodating Good Clients
"It will permit us to deal with a category of clients who are good clients of ours in investment banking and underwriting but who for credit quality reasons can't deal with us on swaps," said William Broeksmit, a managing director at Merrill Lynch.
Several banks are said to be considering whether to create subsidiaries similar to Merrill Lynch Derivative Products. "We have been looking at the same possibility for some time," said one money-center banker who spoke on condition that he and his bank not be identified. "I think several banks have."
Ironically, the capital requirements of such a subsidiary may be too high for many of the institutions that need them. Merrill Lynch's new offshoot has $300 million in common equity and $50 million in preferred, and any bank that can afford to set aside that much equity in a new subsidiary probably has a rating high enough so the subsidiary is unnecessary.
Nevertheless, a number of banks are trying hard to gain market share in swaps. Manufacturers Hanover Corp. and Chemical Banking Corp., for example, have indicated an intention to become more active in the business after they merge. Indeed, officials there hope proceeds from a $1.25 billion stock offering will lead rating agencies to raise the new Chemical Bank's credit rating.
As for Bankers Trust, even George Salem of Prudential Securities, the analyst who pressed the bank at the October meeting to come clean on the swaps exposure, does not worry that the addition to nonperforming assets is a serious glitch. "I still consider the bank one of the premier players," he said.
Table : Tops in Swaps
Banks hold a commanding share of interest rate swaps Interest rate swaps Market (in billions) share *Citicorp $222.0 6.89%
ChaseManhattan 208.2 6.46J.P. Morgan 194.6 6.04
Trust 190.2 5.91
Pacific 122.3 3.80 * As of 12/31/90 Source: Swaps Monitor
PHOTO : The Swaps Count