"In a swap, parties agree to exchange interest payments, usually a fixed payment for one that varies based on an index."

A story on Bloomberg with lots of interesting points:

"By Michael McDonald and Michael Quint

Dec. 24 (Bloomberg) -- Six years after embarking on an effort to lower borrowing costs using derivatives, New York is watching those savings evaporate.

The state( THAT'S CORRECT, THE GOVERNMENT BOUGHT SWAPS ) says it paid bankrupt( NOW YOU KNOW WHY THIS WAS A DISASTER. IT TRIGGERED A WHOLE INFINITY OF PEOPLE HAVING TO GET CASH. IT'S LIKE A BANK RUN ) Lehman Brothers Holdings Inc. and other Wall Street banks at least $75.9 million since March to end interest-rate swap contracts that were supposed to lock in below-market rates. That money and the costs of issuing new debt to replace bonds linked to swaps( IN THIS ENVIRONMENT ) gone awry are eroding the $207 million in savings New York budget officials say the derivatives produced since 2002.

New York isn’t alone. Lehman’s bankruptcy filing on Sept. 15 triggered the termination of similar contracts across the country, forcing state and local governments and other borrowers in the $2.67 trillion municipal-debt market to buy out the agreements( PAY MONEY BACK ). They suddenly find themselves making unexpected payments at a time when their revenue is already under pressure from the worst recession since World War II ( A TERRIBLE TIME TO HAVE TO COME UP WITH CASH ).

“People are fixing problems right now,” said Nat Singer, managing partner at Swap Financial Group in South Orange, New Jersey, and the former head of municipal derivatives at Bear Stearns Cos. The number of new deals has shrunk to a “fraction” of the amount a year ago as issuers unwind failed swaps( BECAUSE OF THE BANKRUPTCY ) with Lehman, Singer said.

Bentley University in Waltham, Massachusetts, and a school district in Pennsylvania vowed never to use swaps again after losing money. The added costs in New York come as the state faces a record $15.4 billion budget deficit over the coming 15 months.

Lowering Costs

In a swap, parties agree to exchange interest payments, usually a fixed payment for one that varies based on an index. Borrowers may benefit by using swaps to lower interest expenses or lock in rates for future bond sales."

Here's a definition:

"An exchange of interest payments on a specific principal amount. This is a counterparty agreement, and so can be standardized to the requirements of the parties involved. An interest rate swap usually involves just two parties, but occasionally involves more. Often, an interest rate swap involves exchanging a fixed amount per payment period for a payment that is not fixed (the floating side of the swap would usually be linked to another interest rate, often the LIBOR). In an interest rate swap, the principal amount is never exchanged, it is just a notional principal amount. Also, on a payment date, it is normally the case that only the difference between the two payment amounts is turned over to the party that is entitled to it, as opposed to exchanging the full interest amounts. Thus, an interest rate swap usually involves very little cash outlay."

And an example:

Copyright ®2004 International Swaps and Derivatives Association, Inc.
Alfa Corp Strong
Financial
Floating rate payment
(3-month Libor)
Fixed rate payment
(5% s.a.)
Terms:
Fixed rate payer: Alfa Corp
Fixed rate: 5 percent, semiannual
Floating rate payer: Strong Financial Corp
Floating rate: 3-month USD Libor
Notional amount: US$ 100 million
Maturity: 5 years
Interest Rate Swap example
• Alfa Corp agrees to pay 5.0% of $100 million on a semiannual basis to
Strong Financial for the next five years
– That is, Alfa will pay 2.5% of $100 million, or $2.5 million, twice a year
• Strong Financial agrees to pay 3-month Libor (as a percent of the notional
amount) on a quarterly basis to Alfa Corp for the next five years
– That is, Strong will pay the 3-month Libor rate, divided by four and multiplied
by the notional amount, four times per year
• Example: If 3-month Libor is 2.4% on a reset date, Strong will be obligated to pay
2.4%/4 = 0.6% of the notional amount, or $600,000.
– Typically, the first floating rate payment is determined on the trade date
• In practice, the above fractions used to determine payment obligations
could differ according to the actual number of days in a period
– Example: If there are 91 days in the relevant quarter and market convention is to
use a 360-day year, the floating rate payment obligation in the above example
will be (91/360) × 2.4% × $100,000,000 = $606,666.67.
A fixed-for-floating interest rate swap is often referred to as a “plain vanilla” swap because it is the most commonly encountered structure"

"New York agencies used them to lower the cost of almost $7 billion in bonds sold between 2002 and 2005, according to an Oct. 30 report from the budget division. The average fixed rate the agencies agreed to pay Lehman and other banks was 3.78 percent, compared with 4.5 percent if they had sold conventional tax-exempt debt( THEY GOT A LOAN AT LOWER INTEREST ), officials calculated.

The state failed to comprehend the extent of the risks( TOO MUCH ) involved in entering into the long-term contracts, which often last more than 20 years, the report said. They included the likelihood an investment bank would go out of business, triggering the termination of the agreement ( THAT'S IT ).

930,000 Contracts

“One of the main risks with swaps, which is that a sudden bankruptcy of a counterparty could terminate a swap in unfavorable mark-to-market conditions( CURRENT PRICES ), was not effectively addressed in the existing laws and agreements,” the budget division wrote in its annual report.

A budget-division spokesman, Matt Anderson, said in an e- mail that “given the current volatility in the market, we currently don’t anticipate entering into further swap agreements at this time.”

Lehman had about 930,000 derivatives( OH MY ) contracts of all types when it collapsed, according to bankruptcy filings. About 30,000 remain open( THAT'S NOT BAD WORK ), Robert Lemons, a Weil, Gotshal & Manges lawyer representing Lehman, said last week. The contracts are worth billions of dollars to Lehman’s creditors, though their exact value isn’t clear, he said.

The cost of ending a contract depends on current interest rates. Since New York and other issuers agreed to pay a fixed rate to Lehman when borrowing costs were higher, they must pay the bank to end the deals( THAT'S IN THE CONTRACT ). The three-month dollar London interbank offered rate, or Libor, upon which many agreements are based has tumbled to 1.466 percent from 5.5725 percent in September 2007.

Swaps Approval

Because they are private agreements, no comprehensive data exist on how many municipalities( GOVERNMENTS ) are involved in the almost $400 trillion interest-rate derivatives market or the total paid to exit the contracts. Derivatives are contracts whose value is tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather( TRUE ).

New York passed a law in 2002 expanding the ability of state agencies and authorities to use swaps. It was signed by then-Governor George Pataki, a Republican. New Jersey, California and other states also use derivatives in their public financing.

Bentley University entered into swaps with Lehman and Charlotte, North Carolina-based Bank of America Corp. on $85 million of debt between 2003 and 2006. The school also had to pay a fee to end the swaps when Lehman collapsed, based on its contracts with the bank.

Upfront Cash

“It’s going to take awhile for people to get comfortable again, if ever,” said Paul Clemente, the chief financial officer at Bentley, who declined to disclose the amount of the fee. “As far as the future for interest-rate swaps, for me there is no future.”

Some borrowers also use swaps as a way to generate upfront cash, an attractive feature as the recession eats into municipal finances. At least 41 states and the District of Columbia face a combined budget shortfall of $42 billion this fiscal year, the Center on Budget and Policy Priorities in Washington, a non- partisan budget and tax analysis group, said Dec. 23. The estimate on Oct. 10 was $8.9 billion.

The Butler Area School District in Pennsylvania decided in August to pay JPMorgan Chase & Co. $5.2 million to back out of such a deal, more than seven times what it was paid to enter the agreement, rather than risk losing even more money over the 18- year contract. The district superintendent, Edward Fink, said he now thinks it’s inappropriate for school systems to dabble in such trades( NOT COMPETENT ), even though they were explicitly backed by the General Assembly in 2003.

Valuing Risk

JPMorgan said in September it would stop selling derivatives to states and local governments amid federal probes into financial advisers and investment bankers paying public officials for a role in swap agreements( COLLUSION ).

Borrowers “never put a value on the risks associated with the swaps( THE LENDERS SHOULD HAVE MADE IT PLAIN. THIS IS AT LEAST NEGLIGENCE ),” said Joseph Fichera, president of New York-based Saber Partners LLC, a financial adviser to corporate and public sector borrowers. They only estimated the savings investment bankers and advisers were telling them they would get, he said.

The use of swaps began faltering in February when the market for auction-rate securities collapsed. States, local governments and nonprofits sold about $166 billion of the debt, and as much as 85 percent of that was then swapped to fixed rates, according to Fichera.

Bond Insurers

The collapse of the auction-rate market left issuers such as the Port Authority of New York and New Jersey paying weekly or monthly rates of up to 20 percent. The swap agreements failed to adjust to swings in the underlying variable rates, leaving New York and others exposed to higher borrowing costs.

Interest rates on other types of municipal variable-rate debt also rose this year as investors boycotted bonds backed by MBIA Inc., Ambac Financial Group Inc. and other insurers that lost their AAA ratings because of their expansion into subprime- linked credit markets.

Some borrowers entered into new swaps after Lehman’s collapse, agreeing to pay higher than market rates in exchange for upfront payments to help cover the termination fees they owed Lehman( INTERESTING ), according to Swap Financial’s Singer. London-based Barclays Plc, which acquired Lehman’s brokerage, is among the banks bidding on this business, he said.

“The combined message from all of that is you cannot have complete confidence in your counterparty,” said Milton Wakschlag, a municipal finance lawyer in Chicago at Katten Muchin Rosenman LLP. “People will be taking a hard look at some of the conventions of the marketplace” after they finish cleaning up from Lehman’s bankruptcy."

I consider this negligence if the borrowers were not clearly explained the risk. You also see Fraud and Collusion in this post. Point taken.

"This process repeats itself and eventually market prices will develop."

Derivative Dribble with another excellent post:

"A Higher Plane

In this article, I will return to the ideas proposed in my article entitled, “A Conceptual Framework For Analyzing Systemic Risk,” and once again take a macro view of the role that derivatives play in the financial system and the broader economy. In that article, I said the following:

“Practically speaking, there is a limit to the amount of risk that can be created using derivatives. This limit exists for a very simple reason: the contracts are voluntary, and so if no one is willing to be exposed to a particular risk, it will not be created and assigned through a derivative. Like most market participants, derivatives traders are not in engaged in an altruistic endeavor. As a result, we should not expect them to engage in activities that they don’t expect to be profitable. Therefore, we can be reasonably certain that the derivatives market will create only as much risk as its participants expect to be profitable.” ( VERY TRUE )

The idea implicit in the above paragraph is that there is a level of demand for exposure to risk ( TRUE ). By further formalizing this concept, I will show that if we treat exposure to risk as a good, subject to the observed law of supply and demand, then credit default swaps should not create any more exposure to risk in an economy than would be present otherwise and that credit default swaps should be expected to reduce the net amount of exposure to risk ( TRUE ). This first article is devoted to formalizing the concept of the price for exposure to risk and the expected payout of a derivative as a function of that price. ( A GOOD IDEA )

Derivatives And Symmetrical Exposure To Risk

As stated here, my own view is that risk is a concept that has two components: (i) the occurrence of an event and (ii) a magnitude associated with that event. This allows us to ask two questions: ( 1 )What is the probability of the event occurring? ( 2 ) And if it occurs, what is the expected value of its associated magnitude? We say that P is exposed to a given risk if P expects to incur a gain/loss if the risk-event occurs. We say that P has positive exposure if P expects to incur a gain if the risk-event occurs; and that P has negative exposure if P expects to incur a loss if the risk-event occurs.

Exposure to any risk assigned through a derivative contract will create positive exposure to that risk for one party and negative exposure for the other ( THIS IS WHAT I SAID WAS A LOSS FOR ONE AND A GAIN FOR THE OTHER ). Moreover the magnitudes of each party’s exposure will be equal in absolute value ( THEY WILL BALANCE OUT ). This is a consequence of the fact that derivatives contracts cause payments to be made by one party to the other upon the occurrence of predefined events ( TRUE ). Thus, if one party gains X, the other loses X( I SAID THAT ABOVE. I AGREE ). And so exposure under the derivative is perfectly symmetrical ( TRUE ). Note that this is true even if a counterparty fails to pay as promised ( TRUE ). This is because there is no initial principle “investment” in a derivative. So if one party defaults on a payment under a derivative, there is no cash “loss” to the non-defaulting party ( TRUE ). That said, there could be substantial reliance losses ( TRUE ). For example, you expect to receive a $100 million credit default swap payment from XYZ, and as a result, you go out and buy $1,000 alligator skin boots, only to find that XYZ is bankrupt and unable to pay as promised. So, while there would be no cash loss, you could have relied on the payments and planned around them, causing you to incur obligations you can no longer afford ( TRUE ). Additionally, you could have reported the income in an accounting statement, and when the cash fails to appear, you would be forced to “write-down” the amount and take a paper loss ( TRUE ). However, the derivatives market is full of very bright people who have already considered counterparty risk, and the matter is dealt with through the dynamic posting of collateral over the life of the agreement, which limits each party’s ability to simply cut and run ( TRUE ). As a result, we will consider only cash losses and gains for the remainder of this article.

The Price Of Exposure To Risk

Although parties to a derivative contract do not “buy” anything in the traditional sense of exchanging cash for goods or services, they are expressing a desire to be exposed to certain risks ( THAT'S IT ). Since the exposure of each party to a derivative is equal in magnitude but opposite in sign, one party is expressing a desire for exposure to the occurrence of an event while the other is expressing a desire for exposure to the non-occurrence of that event ( TRUE ). There will be a price for exposure. That is, in order to convince someone to pay you $1 upon the occurrence of event E, that other person will ask for some percentage of $1, which we will call the fee ( PREMIUM ). Note that as expressed, the fee is fixed. So we are considering only those derivatives for which the contingent payout amounts are fixed at the outset of the transaction. For example, a credit default swap that calls for physical delivery fits into this category. As this fee increases, the payout shrinks for the party with positive exposure to the event ( TRUE ). For example, if the fee is $1 for every dollar of positive exposure, then even if the event occurs, the party with positive exposure’s payments will net to zero ( TRUE ).

This method of analysis makes it difficult to think in terms of a fee for positive exposure to the event not occurring (the other side of the trade) ( YOU KEEP THE FEES ). We reconcile this by assuming that only one payment is made under every contract, upon termination ( THAT'S IT ). For example, assume that A is positively exposed to E occurring and that B is negatively exposed to E occurring. Upon termination, either E occurred prior to termination or it did not. ( OKAY )

If E did occur, then B would pay to A, where F is the fee and N is the total amount of A’s exposure, which in the case of a swap would be the notional amount of the contract":

Under a typical CDS, the protection buyer, B, agrees to make regular payments (let’s say monthly) to the protection seller, D. The amount of the monthly payments, called the swap fee, will be a percentage of the notional amount of their agreement. The term notional amount is simply a label for an amount agreed upon by the parties, the significance of which will become clear as we move on. So what does B get in return for his generosity? That depends on the type of CDS, but for now we will assume that we are dealing with what is called physical delivery. Under physical delivery, if the reference entity defaults, D agrees to (i) accept delivery of certain bonds issued by the reference entity named in the CDS and (ii) pay the notional amount in cash to B. After a default, the agreement terminates and no one makes anymore payments. If default never occurs, the agreement terminates on some scheduled date. The reference entity could be any entity that has debt obligations, like AIG.

"If E did not occur, then A would pay . If E is the event “ABC defaults on its bonds,” then A and B have entered into a credit default swap where A is short ( DEFAULT ) on ABC bonds and B is long ( NO DEFAULT ). Thus, we can think in terms of a unified price for both sides of the trade and consider how the expected payout for each side of the trade changes as that price changes ( BASED UPON THE CHANCE OF DEFAULT ).

Expected Payout As A Function Of Price

As mentioned above, the contingent payouts to the parties are a function of the fee. This fee is in turn a function of each party’s subjective valuation of the probability that E will actually occur( IN THIS IT'S LIKE INSURANCE ACTUARIAL TABLES ). For example, if A thinks that E will occur with a probability of , then A will accept any fee less than .5 since A’s subjective expected payout under that assumption is . If B thinks that E will occur with a probability of , then B will accept any fee greater than .25 since his expected payout is . Thus, A and B have a bargaining range between .25 and .5. And because each perceives the trade to have a positive payout upon termination within that bargaining range, they will transact ( THEY BASE THEIR ACTUAL INVESTMENT ON THE PROBABILITY OF THE EVENT OCCURING IN THEIR OPINION ). Unfortunately for one of them, only one of them is correct ( THIS IS WHERE PEOPLE FEEL IT'S LIKE GAMBLING AND NOT LIKE INSURANCE ). After many such transactions occur, market participants might choose to report the fees at which they transact ( ON AN INDEX ). This allows C and D to reference the fee at which the A-B transaction occurred. This process repeats itself and eventually market prices will develop ( FORMING AN INDEX, AND, POSSIBLY, AN EXCHANGE ).

Assume that A and B think the probability of E occurring is and respectively. If A has positive exposure and B has negative, then in general the subjective expected payouts for A and B are and respectively. If we plot the expected payout as a function of F, we get the following:

The red line indicates the bargaining range. Thus, we can describe each participant’s expected payout in terms of the fee charged for exposure( TRUE ). This will allow us to compare the returns on fixed fee derivatives to other financial assets, and ultimately plot a demand curve for fixed fee derivatives as a function of their price ( TRUE )."

It is important to understand each point as he goes along, so that you can see that the investment has defined terms, and is thus Priceable and Saleable.

Why do I believe that this is so important? Because I do not believe that these investments are that complex. I believe that it is very easy to explain the purpose and risk of these investments, even to people who do not have the ability to understand how the CHANCE OR POSSIBILITY OF THE RISK is determined, which is where the real complexity is located.

Hence, I believe that Fraud, Negligence, Fiduciary Mismanagement, and Collusion, are the main problems associated with these investments in the real world. For example, the iffy nature of the models used to determine the Chance or Possibility of the Risk were known, and all that needed to be explained to a buyer is just that. The methods are iffy.

Stop looking at the investments for the cause of this crisis. It's a charade.