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What Two Risks From Rising Interest-Rates Could Each Trigger A New Global Crisis?

 -- Published: Thursday, 1 October 2015 | Print  | Disqus 

By Daniel Amerman, CFA

Why are interest rates at historic lows in the United States and around the world? 

The widely-accepted answer is that very low interest rates exist for the purpose of stimulating economic growth and corporate profits, and are thereby helping the United States and other nations that are struggling with persistent and deep-rooted economic and unemployment problems.

However, if we accept this answer, then another question arises. If the US economy is booming while unemployment purportedly nears a mere 5% - then why do interest rates remain so low? Why the continuous drama about whether the Federal Reserve will slightly increase interest rates?

A truly healthy economy and stock market should by definition be able to easily handle a minor increase in interest rates, keeping in mind that what is proposed is still only a small fraction of what market rates previously were for decades on end.

So why the fear by both the Fed and the markets?

To understand, we need to explore why these very low interest rates were created in the first place and have remained in place for all these years: they are a defensive attempt to prevent what could otherwise very quickly become two different potential disaster scenarios for global financial markets.

Now just to be very clear - this is not a "gloom & doom" analysis. Neither threat is inevitable and there are many possible economic and political futures. 

But the two threats are nonetheless real, there is enormous latent or stored energy in each threat, and each could indeed swiftly bring down the global financial system as we know it, along with the value of our individual savings and investments. Now, whether a "triggering event" does indeed occur which releases the stored energy and changes the world and our own financial security and retirements along with it - that is the heart of the real question. 

The most likely "triggering event" would be a substantial future increase in interest rates.  And it is simply impossible to explain the past or the present of interest rates - let alone make informed judgments about the path ahead - without understanding the constraints imposed by the attempted containment of these dual risks.

Very Low Interest Rates: Trying To Control Two Global Risks

The main reason for persistent very low interest rates is the threat to the US and global financial system from direct interest-rate risk as well as derivatives interest-rate risk.

Those risks constitute two distinct but deeply-intertwined potential disaster scenarios which are not only still out there but each are significantly more dangerous than they were before 2008. And if the Federal Reserve were to ever completely lose control of interest rates these risks could still take down the global financial system in a matter of days through a combination of counterparty risk, financial contagion and liquidity risk.

The first level of interest-rate risk is that of deeply indebted sovereign governments who already can't pay their bills. As an example, the United States is currently over $18 trillion in debt an amount approximately equal to its total economy in size. This is almost double the total federal debt of $8.9 trillion that was outstanding in 2007, before the financial crisis of 2008.

This means, all else being equal - the government would have to make twice the interest payments it made in 2007, if interest rates were to return to 2007 levels. And twenty times the interest payments made in 1980 (when the debt was $0.9 trillion) would be due, if interest rates were to ever return to the far higher levels of previous decades.

With each year that goes by, as the debt continues to mount, the interest payments on that larger debt also increase. This is an issue even with the current extremely low level of interest rates. And this situation could quite quickly turn into a disaster scenario if substantively higher interest rates - i.e., normal free market rates - were to return.

Which is exactly why interest rates are currently so low. According to the US Treasury Department, the average interest rate on all US government debt outstanding is somewhat less than 2.5% (not including Treasury Inflation-Protected Securities).

As explored here, once interest rates have had the time to reset among the various maturities of debt outstanding, a 5% increase in borrowing costs for the federal government with current levels of debt outstanding would triple interest costs.  This would raise the federal deficit by $900 billion per year.

And if we take into account the risk involved with an effectively bankrupt nation that can't pay for imports, and we add not 5% but 10% to the cost of the federal debt which is still well below the peak seen in the early 1980s when there were lesser economic issues then we would see a five times increase in annual interest payments, with the annual total deficit soaring to well over $2 trillion dollars per year. With this fantastic increase in interest expenses being financed by still higher deficits, which in turn accelerates the increases in debt outstanding, which then further ratchets up interest expenses, which must be paid for by still more borrowing clearly this rapidly creates an impossible situation.

It should also be noted that a similar level of interest rate risk is faced by the deeply indebted major cities of the United States, as well as the heavily indebted states.  So a substantial increase in interest rates would not only send federal deficits soaring but also state and local deficits as well, which would then likely lead to major increases in state & local tax rates. Major corporations which can directly access the capital markets via bond borrowings have also taken advantage of pervasive low interest rates to load up on low cost debt as well.

What the federal government, state and local governments and major corporations of the United States have in common then, is a very powerful motivation to keep interest rates relatively low for the indefinite future ­ albeit at the expense of savers & investors.

Interest-Rate Derivatives Danger

Unmanageable sovereign debt and compounding interest costs on that debt is a huge problem for the world, but it's not the largest problem.

The greatest danger is the over $500 trillion of interest-rate derivatives that are currently outstanding, according to the Bank For International Settlements.

Wall Street and the major financial firms around the world have created fantastic paper profits and paid out enormous personal bonuses on the promise that they can do something which they in fact can't do, nor have they ever had the ability to do.

The thinly-capitalized financial firms have promised the major borrowers of the world which include state, provincial and municipal governments, as well as corporate borrowers, as well as commercial real estate owners that through the purchase of interest-rate derivatives products, these borrowers will be protected from loss in the event that interest rates shoot up.

Now of course when push came down to shove in practice, Wall Street was completely incapable of covering even the relatively minute damages from the collapse of the $1.2 trillion subprime mortgage derivatives market.

In the graph below, we take a visual look at the size of the subprime mortgage derivatives market at the time of its collapse, and we compare it to the current interest rate derivatives market.  You may need to squint and lean towards the screen to see the blue line for the subprime mortgage derivatives market, as it is only full 1 pixel wide, but it is indeed there, even if it is hard to see in comparison to an interest rate derivatives market that is more than 400 times its size.

Speaking as a former investment banker who in the 1980s helped to create some of the most complex derivatives that had existed up until that time, and who later had a McGraw-Hill book published on the subject titled, "Collateralized Mortgage Obligations, Unlock The Secrets Of Mortgage Derivatives", (1996), the issue is that Wall Street has been ignoring two extraordinary risks that are associated with derivatives. And despite these risks having been proven in practice, they continue to be widely ignored today by Wall Street, by governmental regulators, and by the rating agencies.

Correlation Risk

Derivatives carry two distinct but intertwined dangers, and the first is correlation. We can view derivatives as being a form of an insurance contract in many cases, where protection against possible losses is being sold in exchange for premium income. 

As an example, an insurance company might sell fire insurance policies in different neighborhoods in California, New York, and Florida. They would expect to get a statistically predictable level of fires to occur in an uncorrelated manner, i.e., whether a fire occurs in New York has nothing whatsoever to do with whether a fire happens in California. Because relatively few fires occur each year compared to the number of policies that have been written, they can therefore cover their risks and consistently earn profits as well.

The problem with subprime mortgage derivatives in 2008 was that when the market turned to disaster the whole subprime market went down together. Among the many other issues with subprime mortgages was the assumption that perhaps a pocket would go bad in California, or perhaps Florida, but the mortgages would be fine in the rest of the nation, and the income from performing subprime loans in the rest of the nation would cover the losses.  Much like what would happen with fire insurance, or auto insurance.

The difference was that the same national firms were making the same bad lending decisions in every part of the nation simultaneously. So the risks turned out to be highly correlated ­ they hit everywhere at the same time. And the reserves which had been set up to cover uncorrelated risks evaporated almost instantly, because they were grossly inadequate when it came to meeting the promises that had been entered into by the Wall Street firms all across the nation.

And when we look at interest-rate derivatives we're looking at an even more correlated degree of risk.

When interest rates rise, they rise across the board for an entire nation, and they may indeed help trigger interest-rate increases in other nations as well. Issuers have entered into trillions of dollars of contracts with Wall Street and other financial firms to cover their risk if interest rates increase. And if interest rates do increase substantially they increase for the nation as a whole, in every state, for every borrower, and for every category.

So there is close to 100% correlation the simultaneous losses being incurred could be likened to one firestorm spreading over the entire country.

And the reserves that were established to cover statistical assumptions of uncorrelated losses quickly disappear when it is correlated losses on a national basis that happen instead.

Wall Street and the banking industry remain as highly over-leveraged as ever. Just where are these hidden reserves of many trillions of dollars worth of capital to honor all of the derivatives contracts?

As an example, let's say a city had issued $100 million in variable rate debt, and they wanted to borrow at the very low short term interest rate of 2%, but they also wanted to have protection against having to pay more if interest rates rose. For this protection, they would likely be highly encouraged to enter into a derivatives contract, where essentially the city would pay a financial company to cover the risk if rates went up.  So if short-term interest rates rose from 2% to 7%, the city would have to pay $7 million a year in interest payments on their $100 million debt (instead of $2 million), but they could then turn to financial company who would pay the city the $5 million per year difference, leaving the city's borrowing costs unchanged.

Now the issue is that if interest rates were to rise by 5% across the entire nation, and every level of state and local government, as well as mass numbers of corporations and commercial real estate owners were to all owe their investors 5% higher interest rates, and they all simultaneously went to the financial firms which provided them with interest-rate derivatives and essentially said "I want the 5% you contractually promised to pay me if interest rates went up by 5%" where, precisely, is the fantastic source of funds for the system as a whole to make good on these derivatives contracts for potentially year after year?

Importantly, most of the dollar volume of derivatives outstanding are not actually independent risks, but instead represent the same risk being resold time and again in different forms, which in theory reduces the risks for each firm on a micro basis.  However, we also know that in practice this creates an elaborate chain of promises (a.k.a. systemic "counterparty risk") that links together the solvency of all of the financial firms. And it's the estimation of the profitability of each one of these levels of interconnected promises which has allowed for the payment of so much bonus income.

And make no mistake - it is the bonus income and other personal incentives for executives that has led Wall Street and the rest of global financial system to take on hundreds of trillions of dollars worth of interest-rate derivatives risk.

But what it all comes down to is credibility. Do Wall Street and the other providers of interest-rate derivatives actually have the capital tucked away somewhere to cover the many trillions of dollars in increased interest payments for the entire nation (and the entire world), year after year, if rates were to rise by 5% or 10% or even more?

In practice, we know that Wall Street wasn't good for their promises on a little more than $1 trillion in subprime mortgage derivatives.  There are more than 400 times as many interest-rate derivatives currently outstanding as there were subprime mortgage derivatives in 2008. There's no possible way. It would be an annihilation scenario, short of even greater levels of government interventions.

The basic relationship is that the banks and financial companies sell insurance contracts they couldn't possibly honor if there is a substantial and sustained increase in interest rates, in exchange for what are essentially lucrative insurance premiums. Honoring the insurance if rates rose to the market levels of past decades would bankrupt the system. So the governments keep rates low so that the system isn't destroyed, and the banks keep the profits from the "insurance" that they won't have to pay out on.

Another way of looking at this is to say that traditional insurance companies generally sell protection against "natural" risks they do not control but are considered to be statistically predictable, within a fairly tightly regulated industry. In contrast, interest-rate derivatives are a relatively lightly regulated industry where the product being sold protection against interest rate changes is often under the more or less direct control of the central banks and governments. So long as enough insurance is sold, i.e. more than $400 trillion in notional interest-rate derivatives outstanding, then the governments have an existential interest in making sure that the "insurance" claims against the financial firms never reach the level that would imperil the stability of the system.

One could even say that by having created such a fantastically large level of risk the financial firms are effectively blackmailing the governments to make sure they never have to pay out, and the governments are allowing this because 1) so much money is being made by connected insiders; 2) it hasn't actually blown up yet; and 3) the voters have no clue about what is actually happening.

There is an elaborate vocabulary and mathematics for derivatives that goes well beyond the knowledge of most financial professionals, let alone the general public. They are created by the largest and most prestigious financial firms in the world. Yet, once the veneer of these layers of impenetrable mathematics, jargon, "expertise" and the perception of overwhelming financial authority is pierced what is left is nothing more than a basic form of insurance scam, i.e. collecting premiums for policies that can't be honored.  And if something does goes wrong with that scam then it is all of us who are the ones who will pay together, as taxpayers and investors.

When we understand this, then we can understand what may be the biggest reason of all for why for the indefinite future, interest rates won't be allowed to go to substantially higher levels on a sustained basis. Or at least this won't happen for so long as central banks and governments retain sufficient control to keep interest rates in a relatively low range, when compared to historical levels.

Part II

Part II of this article explores 1) the other extraordinary danger associated with derivatives, which reappeared in practice again in August of 2015 after a long absence; 2) the additional danger of credit derivatives; 3) why derivatives have helped create bail-in regulations around the world; and 4) why both the mainstream and "gloom & doom" schools of investment thought are outdated in this new world of derivatives and government-dominated markets.

Continue Reading The Article

Contact Information:
Daniel R. Amerman, CFA

This article contains the ideas and opinions of the author.  It is a conceptual exploration of financial and general economic principles.  As with any financial discussion of the future, there cannot be any absolute certainty.  What this article does not contain is specific investment, legal, tax or any other form of professional advice.  If specific advice is needed, it should be sought from an appropriate professional.  Any liability, responsibility or warranty for the results of the application of principles contained in the article, website, readings, videos, DVDs, books and related materials, either directly or indirectly, are expressly disclaimed by the author.

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