More Compound Interest

In the previous piece on Interest Rate Swaps (IRSs) it is stated that these derivatives now total some $400 trillion. This is a huge number, yes, but there is some amelioration to this figure. First, this number represents the principle debt that is being hedged and not the interest on this principle. Therefore, the amount of interest that is being hedged must be something like 5 or 6% of this figure, or about $20-$24 trillion -- still a very big number, but not as large as all credit default swaps (including the Collateralized Debt Obligations, CDOs, arising from the sub-prime mortgage industry) that may total $60 trillion.

Also, in most cases (except for runaway inflation … a very important exception) the amount of exposure to the guarantor or guarantee against interest rate swings would be smaller than this number, say just one or two percentage points (100 to 200 basis points). This suggests that the total risk exposure from IRSs is smaller still, say around $4-$8 trillion, far from a trivial number. But this may have also effectively doubled (to roughly $10 trillion) the total counter-party risks that financial institutions found themselves burdened with last summer when the LIBOR swung up one and one-half basis points at the same time as Credit Default Swaps on sub-prime mortgages were being called in … if (and a big “if”) we assume just the first level of CDS exposure. One more salient point, unlike CDSs, the IRSs are zero-sum. In other words for each financial loser, there should be, without defaults, a financial winner. Who they are and were I haven’t a clue.

But still the $400 trillion of IRS’s principal does show the degree to which the world financial markets had been over-leveraged … perhaps encouraged to do so by the false sense of security that IRS derivatives seemed to provide them. This is a good reason why this whole notion of interest rate swing hedging should be rethought in the future. It might be OK if just a few do it, but not OK if everyone is doing it.