Could the next major disaster for the world's big banks be looming in the swamps market?

"A worst-case scenario would be a very large firm with a lot of swaps unable to perform vis-a-vis a whole variety of counterparties who aren't well capitalized," says Mary Schapiro, a member of the Securities and Exchange Commission. "It would be a chain reaction coming out from the hub of a wheel."

Last Things Banks Would Need

After debacles in commercial real estate, leveraged buyouts, and Latin debt, U.S. banks hardly need another dose of trouble. But regulatory from Ms. Schapiro to New York Fed President Gerald Corrigan have expressed concern that swaps have the potential to rock world financial markets.

In theory, swaps are fairly simple: One company hedges interest rate risk or foreign-currency risk by agreeing to exchange its obligations - such as a floating-rate payment - for one that better suits its balance sheet, such as a fixes-rate payment.

But in practice, the swaps market is a byzantine web with thousands of credit relationships among the world's financial institutions.

Indeed, the market is enormous. In last year's second half alone, banks and other dealers created basic interest rate swaps and currency swaps with underlying principal of $1.027 trillion. Banks frequently participate in these transactions to hedge their own portfolios and to make profits as dealers.

The figure doesn't include more complex derivative products, such as commodity swaps based on fluctuations in the prices of oil and metals or forward contracts based on the performance of international stock indexes. Including these could significantly increase the total -- and the risk.

Single swap transactions can be huge.

$2 Billion Deals?

J.P. Morgan & Co., for example , is rumored to have created a few swap contracts with notional values of as much as $2 billion each. Morgan officials declined to comment on specific transactions.

Swaps and other derivatives can be designed to hedge almost any exposure which is precisely what makes them so useful. A company with operations in Germany and investments in Japan could buy an interest rate swap based on the performance of a Nikkei stock index with payments made in German marks.

One problem: Such individualized contracts can't readily be traded on any secondary market. That makes the swaps business tough for regulators to monitor.

"When you trade through an exchange, there's a clearing house, and ... regulators [have] access to position size," said the SEC'c Ms. Schapiro, who was formerly general counsel for a futures industry trade group and a onetime futures industry regulator. "Not knowing size and credit risk really poses some concerns about the impact of a credit going down.

"An exchange isn't fool-proof," she said, "but it gives you time to get some innocent bystanders out of the way."

Snowball Potential

Regulators also worry that problems with derivatives could spread quickly. A senior bank regulator who asked not to be named says it is easy to envisage a situation in which a major dealer has large amounts of swap contracts with six regional banks. Two of these, in turn, could have lots of swaps and other credit relationships with a smaller bank.

If the major dealer were to fold, to take the simplest leg of a potential collapse, the direct bank counterparties would be hit hard.

But the shock waves would be felt as well by the smaller bank, which had no direct exposure to the dealer.

Such a series of problems "would be scary as hell," the regulator said.

One thing that most disturbs regulators is their limited access to information on the derivatives activities of the banks they are charged to watch.

Without data on the unregulated markets, they have little warning about potential credit problems and no time to prescribe remedies, such as higher reserves.

Interlocked Markets

Transactions get even more complicated when derivatives contracts in one market -- such as interest rate swaps -- are offset with foreign-currency or stock market index products in other markets for hedging or other business reasons. The parties that would be implicated in a collapsed swap then multiply.

Another fear: The technology for tracking derivatives at some banks may not have kept pace with the market's explosive growth. Regulators fear that banks themselves may not truly know the extent of their exposures.

What could cause problems with derivatives in the first place?

Credit quality -- the usual suspect -- tops the list. Nearly 60% of chief financial officers in a recent survey ranked credit quality as their chief concern about derivatives, said Michael Rulle, a managing director at Lehman Brothers Inc., in a recent speech.

Big Bucks, Plus Concentration

There appears to be plenty to fret about. At the end of 1991, the top 30. U.S. bank holding companies were owed a total of $150 billion by counterparties in various interest rate and currency swaps.

What's more, the exposures are concentrated. "There might be about 20 major players worldwide where the bulk of price-making is done," said a banker.

Market is also a concern, chiefly because it could trigger credit problems.

For example, a bank may enter into an interest rate swap with a company that wants to make payments based on floating rates and to receive fixed rates.

The bank agrees to pay 6% fixed rate, then turns around and hedges the commitment through a separate contract with a company that agrees to pay the bank a 6.1% fixed rate in return for a floating-rate payment from the bank.

Vulnerable to Rate Bounces

For a while, everyone is happy.

The companies have the types of interest payments they desire, while the bank pockets the difference between the two fixed-payment rates. In addition, the dealer collects any fees that it might have negotiated for arranging the transaction.

But if interest rates suddenly soared, the first company -- if unable to keep us its floating-rate payments -- would default. The bank in the middle would be left having to make suddenly high interest payments to the second company while receiving a fixed rate of only 6.1%.

One problem contract is unlikely to sink a company or ripple out to many other parties.

But if the first company has a series of floating-rate arrangements and the bank in the middle has done likewise, scores of players could be hurt.

Liquidity Is a Problem

Market risk is heightened by the fact that the swaps markets are not extraordinarily liquid. If a major dealer were to fail, others might stay out of the market until all the dealer's contracts were sold or nullified. That could upset trading activity in other contracts.

Consider what happened when Drexel Burnham Lambert went bankrupt. It had a derivatives portfolio estimated by one banker to have a notional value of as much as $50 billion.

The market weathered Drexel's woes -- but there were some tense moments as bankers tried to get Drexel to settle up its swaps exposure. Its counterparties included many banks and thrifts.

Hard Bargaining

One market participant said there was talk of locking all the swap parties in a room until they agreed to terms for dealing with their Drexel exposures. Ultimately, some banks settled their Drexel swaps at 70 cents on the dollar, according to traders who were in the market.

Proponents of swaps -- who are represented by the International Swap Dealers Association -- say a similar situation today would be easily handled. The markets, they say, have become more liquid, enabling parties who do not want to wait for a bankruptcy court ruling to sell their contracts to other derivatives users.

"We buy swaps all the time" in situations like that, said John Stomber, head of interest rate and currency swaps at Deutsche Bank Capital Corp.

But it's not always that easy.

Bank Broker in a Pickle

J.P. Morgan has been trying for months to broker the sale of several swap contracts between Olympia & York Developments Ltd. and Dai-Ichi Kangyo Bank. The sale, by auction, has been postponed four times and is now scheduled for late this month.

A Morgan spokesman said negotiations are continuing on disposition of the swaps. But several swaps traders say very little interest exists in buying the contracts because their terms do not conform to the standard format developed by the trade group ISDA, a fairly common condition.

In fact, sources said, potential buyers of the O&Y swaps could pick up some loan exposure to the troubled real estate concern. That's because payments on some of the swaps are contingent on O&Y's paying off its loans.

Several bankers said they are just as eager as regulators to limit risks in the derivatives market. ISDA created its standardized contract, which tries to standardize terms for most dealers, as early as 1986, and it continues to push for safety features in the market, they said.

No |New Risks'

"Is [the market] riskless? Absolutely not," said Mark Brickell, a vice president at J.P. Morgan and a director of ISDA.

But he added: "The risks in the transactions are the same we have been managing in traditional bank products. Swap traders may be clever, but they haven't invented any new risks."

Bankers also contend that their derivatives client's credit quality is generally higher than the quality of their loan clients. Borrowers are often companies too small or too risk-laden to go into the capital markets on their own.

Swap participants, by contrast, often bypass bank loan departments. They use derivatives only to manage interest rate or currency risks associated with issuing their securities.

Fearing One Big Collapse

Indeed, default rates on swaps have been low. An ISDA survey published last Wednesday showed that the notional value of losses on swaps was less than half of 1% of the notional value of the dealer's swaps portfolios.

However, even the highest-quality counterparties can run into trouble if they need cash and find that their highly customized contracts are illiquid.

All it would take is one big disaster, some swappers fear, for regulators to start laying heavy hands on the market. In any case, the regulators' worries about the arcane world of derivatives is unlikely to vanish any time soon.

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