There has been much talk by the Federal Reserve about raising interest rates in the US so let us assess the reality behind the rhetoric. Firstly we need to understand what derivatives are and the exposure of US banks to these instruments, for the purpose of this illustration.
A derivative is a financial contract whose value is derived from the performance of underlying market factors, such as interest rates. Derivative transactions include a wide assortment of financial contracts such as structured debt obligations and deposits, swaps as is the case for interest rates, futures, options and variations of all of the aforementioned.
The table below illustrates the notional values of derivatives by their underlining risks. Notional values are regarded as the nominal or face amount that is used to calculate payments made on swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional.
We can see that Interest rate contracts continued to represent the majority of the US derivative market at $147.2 trillion or 76.3 percent of total derivatives during the first quarter of 2016. Note that there has been an overall increase of nearly $12 trillion of total derivatives from the previous quarter.
|Derivative Type||Q1 2016 (Trillions)||Q4 2015 (Trillions)||Q1 2016 (%)||Q4 2015 (%)|
The table below illustrates that these four banks hold 91% of all derivatives in the United States.
|Bank||Q1 2016 (Trillions)|
|JPMORGAN CHASE BANK||$52.911|
|CITIBANK NATIONAL ASSN||$52.052|
|GOLDMAN SACHS BANK||$44.434|
|BANK OF AMERICA||$26.262|
So what are interest rate swaps (derivatives) and why would raising interest rates cause seismic tremors in the financial markets?
An interest rate swap, or derivative contract, is an agreement between two parties to exchange one type of interest payments for another, over a set period of time. The most commonly traded ones are fixed-rate payments for variable-rate payments based on LIBOR (London Inter-Bank Offered Rate), which is how banks charge one another for short-term financing.
With this in mind we have seen that in response to very low short-term interest rates, many U.S. corporations have swapped their long-term (fixed interest rate) debt into short-term (variable interest rate) debt because interest rates are virtually static. The extent of these swaps means that an increase in short-term rates could substantially raise default risks.
Interest-rate derivatives are sold as a protection against interest rate changes and are essentially under central bank and government control. Provided sufficient contracts are sold, currently $147 trillion dollars, then central banks and governments have to ensure that claims against the institutions selling these derivative contracts are not placed at risk of default. Therefore the need to keep interest rates low is an imperative. Should interest rates rise then the losses in derivatives may end up bankrupting a wide range of institutions, including governments, insurance companies, investment houses and commercial banks.
To put this in context, in 2008 approximately $1 trillion in subprime mortgage derivatives where responsible for the financial crash. Now given there are 147 times more interest rate derivatives currently outstanding we can see that the risk of default is significantly greater. From the tables above, we can see that even if only 0.1% of these Interest Rate Derivatives were to default, that would represent losses of $147bn dollars which would be sufficient to wipe out the banks, including the four listed above, causing a systemic financial collapse. Furthermore, if interest rates rises were to occur over a sustained period of time financial institutions who sell these insurance contracts would be unable to honour them and they would default.
This short article serves to illustrate why talk of raising interest rates, by the Federal Reserve, is hot air because it would cause a systemic crash in the financial system which would dwarf the one witnessed in 2008.