How Derivatives Made Your Mortgage Cheaper

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NEW YORK (TheStreet) -- Consumers who are concerned about the impact of derivatives on their finances and the broader economy should consider the benefits over the past 30 years as well as the costs over the last two.

For example, derivatives have helped bring down the cost of mortgage borrowing significantly. Before interest rate swaps were widely adopted, the rate on a 30-year fixed mortgage was over 15%. For almost a decade now, they have remained under 10%.

That's partly because certain products, like interest-rate swaps, allow banks to offset the risk that rates will change dramatically, that people will repay early en masse via refinancing, or that people will stop paying their mortgages altogether -- all of which occurred in recent years.

Similarly, derivatives have helped mitigate the blow of big commodity-price swings on consumer products. Commodity futures are contracts that allow big companies that make food, fly planes or have a vast distribution network that relies on fuel to offset the risk that fuel prices will climb tremendously.

That's partly why during the oil scare in 1974, before derivatives existed, prices surged 11%. In 1979 and 1980, when another fuel crisis was followed by a recession -- and derivatives were still just a glimmer in Wall Street's eye -- prices spiked 11.3% and 13.5%.

But in 2008, when oil prices reached the highest level ever recorded and as the credit crisis was coming to a head, consumer prices rose a measly 3.8%. Inflation hasn't risen above 10% since 1981, when the first major derivatives transaction was structured -- not on Wall Street, but between IBM and the World Bank.

Of course it's silly to argue that mortgage rates and consumer prices owe their stability to derivatives entirely. But there's a definite correlation between derivatives and Main Street that can't be ignored -- unless you sit in the halls of Congress, of course.

The "D" word has received a lot of negative attention since the exotic variety helped to tear down American International Group and some investment banking counterparts. Lawmakers have fueled the hostility and represent a misunderstanding of how they are actually used. They've often used their pulpits to characterize derivatives as profit centers for banks on Wall Street that do little good for average Americans.

One of the most recent attacks came on April 27, when Goldman Sachs executives were grilled about a questionable derivatives deal structured in 2007. Sen. Claire McCaskill (D., Mo.) was particularly incensed, referring to a Goldman honcho as a "pit boss in Las Vegas" and criticizing the synthetic collateralized debt obligation involved in the trade.

"They are instruments that are created so that people can bet on them," said McCaskill. "It's the la-la land of ledger entries. It's not investment in a business that has a good idea. It's not assisting local governments in building infrastructure. It's gambling, pure and simple, raw gambling."

Weeks later, Sen. Blanche Lincoln (D., Ark.) -- who faces a tough re-election battle in the fall -- proposed a strict amendment to the financial reform overhaul. The broader bill proposed by Sen. Chris Dodd (D., Conn.) had already placed restrictions on the Wild West of derivatives trading. It imposed mandated clearing as well as risk-based margin requirements and capital levels.

But Lincoln's proposal threatens to cripple the U.S. derivatives market entirely by forcing banks to effectively wind down or spin off their derivatives operations. The Senate approved the measure as part of the broader bill last week in a vote of 59-39. That bill will now move on to be reconciled with a House version, which doesn't have such tight restrictions on derivatives trading.

It's hard to argue with strict requirements for the "la-la land of ledger entries" that McCaskill invoked. But not all derivatives can be painted with the same broad brush, and the majority of them help consumers by keeping borrowing costs and consumer prices down.

"The government has no idea that the use of derivatives may keep the price of flour down," Rochdale Securities analyst Dick Bove said in a note last week. "They may keep the cost of an airline flight lower than otherwise would be the case. They keep interest rates in check on loans. They facilitate foreign commerce. None of this is understood. None of this has been discussed in the unremitting attacks on the industry."

Still, derivatives can be a frightening thing to average consumers. The word was barely whispered in the mainstream press before its association with multibillion-dollar bailouts. But, in fact, the alphabet soup of CDOs, CLOs, SIVs and CDSs that have been bandied about the Wall Street grave yard account for just 6.6% of the U.S. derivatives market. Interest rate swaps account for 84%, according to the Office of the Comptroller of the Currency.

Here's the way interest rate swaps work: One party agrees to exchange a stream of floating payments for a fixed stream that comes from its partner in the trade. So, if a mortgage lender may have a huge bundle of loans based on rates like LIBOR, whose payments may rise or fall, the lender then exchanges part of that stream for a set, stable cash flow from a counterparty -- another bank, an insurer, or whoever is willing to take the other side of the bet.

The same type of transaction can work with borrowing costs, if a company sets up an agreement with another entity that has access to funds at a cheaper rate. The company can issue debt at Rate X, while the other entity borrows at X-minus-2. They set up a lending agreement and split the difference, but the contract is a type of derivative known as a swap.

Dennis Nason, a former banker who now runs an executive-search firm puts it simply: "It's a swap; it's a derivative; it's not evil."

The mortgage finance giants Fannie Mae and Freddie Mac provide a good example of why derivatives matter, because they rely heavily on swaps to keep rates down. The two entities hold roughly $1.9 trillion worth of notional exposure to interest rate swaps and similar types of products. That covers about 40% of the $4.8 trillion worth of mortgage loans the two firms held on their balance sheets.

The government took over Fannie and Freddie in September 2008, and has since used the firms to bring down mortgage rates to historic lows. Since the month before their bailout to now, rates have dropped more than 150 basis points. Had Fannie Mae not been able to access interest-rate swaps in 2009, as Lincoln's proposal might warrant, its cost of funding would have been 40 basis points higher. Mortgage rates were at 5%, and Fannie's long-term debt costs at 3.71%, leaving little wiggle room in between for such an added expense.

Because the lack of swaps availability would hit lenders, servicers and mortgage buyers, the Securities Industry and Financial Markets Association estimates the cost of a $200,000 home loan would rise by "at least $6,000 to $10,000 and probably more." Researchers at one of the country's biggest banks estimate that mortgage rates would rise 70 basis points if the Lincoln amendment were adopted.

Of course, SIFMA is a lobbyist and the bank is a giant mortgage lender. Both have skin in the game, so their estimates should be viewed in the context of their interests.

David Nowakowski, director of credit strategy at Roubini Global Economics, says "it seems impossible to me to put a number on the effect of this on mortgage rates, but 70bp seems rather steep." Still, he agrees that it could have an impact on mortgages and the banking industry -- at least in the short term.

"I can definitely concur that it would make hedging rate risk more difficult," says Nowakowski. But he later adds that "big banks are very sophisticated ... and will certainly find ways to manage their inventories."

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