Credit Derivatives and Market Fluctuations

It probably does not come as news to anyone that last week saw a lot of movement in global financial markets. The Dow Jones fell the most in any one week in the last five years, whilst in Italy both The Mibtel and S&P/Mib indexes lost gorund during the week. It is far too early to say at this point whether this constitutes the start of a "correction", or all we have is increasing nervousness and market volatility. Nonetheless the consequences of growing concern about the extent of credit risk are already being felt in Italy, most notably in the Italease case.

The impact of what is happening as a result of the losses sustained on derivatives trading at Italease goes well beyond the traditional financial investment community, as this Bloomberg article points out:

Piera Levo and her husband, who run a 15-employee plumbing supply company in northeastern Italy, bought ``insurance'' against interest rate increases from UniCredit SpA in 2000.

Six years later, they paid 85,000 euros ($117,000) to extricate themselves from a derivative known as an interest-rate swap that is normally sold to large companies and fund managers. Derivatives are contracts whose value is based on that of another security, index or commodity, or linked to events such as changes in interest rates.

``I had no idea what I was getting into,'' Levo said. ``I don't even play slot machines. I would never sit down to play blackjack against Alessandro Profumo,'' chief executive officer of UniCredit, Italy's biggest lender.

Italian banks, including UniCredit and Banca Italease SpA, have sold swaps to as many as 100,000 small businesses, according to lawyers and industry groups. Concern about the contracts intensified last month, when Milan-based Italease said about 2,200 clients may lose 600 million euros on derivatives. Italy's central bank this week barred Italease from selling its most-profitable derivatives and ordered directors to resign.

The Bank of Italy estimates that non-financial companies had 3 billion euros of liabilities on derivatives at the end of 2006.

Banks sold swaps to clients as insurance against rising rates. They also made lots of money. Commissions from sales of derivatives represented 48 percent of operating revenue at Italease in the fourth quarter, according to John Raymond, an analyst at CreditSights Inc. in London.


Claus Vistesen made the following very valid point to me (e-mail communication):

"My guess is that there is a lot of this going around (i.e. in Denmark banks are persuading farmers to play the derivatives to hedge their harvests, the problem is just that they are often playing against other banks and of course also the fact they have no idea what they are doing) and really the whole subprime mess is a reflection of this since homeowners are the ones who end up in bankruptcy as well as of course those credit institutions who are exposed to something like +75% or something in subprime loans. Incidentally Scott, thanks for the comment on my credit channel post regarding the investment banks......in this respect FX trading might be comparatively easy and safe but the problem for the average retail investor is that she only needs to fail once and if she happens to be overly leveraged, well ... those books have to be settled at the of each month you know (or three months perhaps depending on the contract and regulations)."

And just in case you aren't sure what "swaps contracts" are (and don't like to ask), then this might help:

In a basic swaps contract, one borrower exchanges the interest payments on its floating-rate debt for the fixed-rate payments of the second. This helps the first borrower protect against rate increases, while the other profits if rates decline.