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Monday, January 3, 2011

Total Return Equity Swaps/WMDs

How many times can a man turn his head And pretend that he just doesn't see
The answer, my friend, is blowing in the wind
The answer is blowing in the wind - Dylan

Suppose you wanted to get a loan, but your balance sheet is looking a bit shaky. You come to me and we make an agreement. I buy your 100 shares of Johnson & Johnson stock, you get the dividends, and each quarter we settle up on the gain or loss in the stock. This removes the stock from your balance sheet and you have increased your liquidity. There has been no change - you've moved the stock, in effect, off balance sheet but you still participate fully in the movement of the stock. You've engaged in a "Total Return Equity Swap".

These swaps are what Buffett was referring to when he called derivatives weapons of mass destruction.

It would seem that anyone with at least a 3rd-grade education could see that this type of swap increases leverage, is designed to manipulate balance sheets, and is dangerous. Unfortunately, our former Chairman of the Federal Reserve didn't grasp the danger of these types of derivatives. His view was that derivatives spread risk to those that can handle it.

This it does. But there are typically at least two sides to an economic action. They do spread risk in a beneficial manner; but they also increase speculation, potentially to dangerous levels. This, of course, is being kept simple - you can imagine the potential abuses in the bond area. If I have too much debt, I can't get a rating on the borrowing I need to do. No problem - let's do a swap and lower my debt/equity ratio.

The big problem, in my opinion, is that there are people who see the dangers of these kinds of instruments (I'm talking broadly now - not just about swaps and derivatives) but they "pretend he just doesn't see" because of short-term economic gains.

To realize our potential as we move into a new decade, we need at some point to stop looking the other way and pretending we don't see.


  1. Is there an actual legitimate business use for these things that adds value in some way?

  2. It cleans up a balance sheet and provides liquidity. It is a way for creators of ETFs to get shares etc. I doubt there is any absolute economic (wealth creating) purpose served by these swaps. As Buffett observed the problem is that they ramp up leverage aggressively.
    As most things in the financial markets swaps started out with legitimate uses. You're German and need to borrow in the U.S. You'll pay high rates because U.S. investors don't know you. We'll find someone U.S. who needs to borrow in Germany with the same problem. Then you each borrow at lower rates in your respective countries and swap cash flows. A win-win situation.

  3. Potential for abuse outweighs the benefits. I'd have to side with Buffet on this.