One of the most popular tricks on Wall Street this year is a new financial technique called "interest rate swaps," a $40 billion business that began only two years ago.
While interest rate swaps may sound mysterious and technical to those outside the financial community, corporations ranging from Sears, Roebuck & Co. to the Washington-based Student Loan Marketing Association have used the technique regularly to cut costs, increase revenue and preserve borrowing power in public capital markets.
Interest rate swaps enable corporations to manage their finances by converting fixed-rate payments and receipts to floating rates, and vice versa.
"The interest rate swap market is growing because these transactions are driven by fundamental economics, not by accounting or tax gimmicks," said Leon Kalvaria, a First Boston Corp. vice president.
Conceptually, interest rate swaps work by separating the interest and principal on financial instruments. For example, a corporation that issues floating-rate debt and swaps it for fixed-rate debt trades only the interest payments, not the debt itself.
The growth of this market also is the result of the versatility of swaps, which can synthetically create assets or liabilities to provide either yield pickups of cost savings, and to the increasingly liquid secondary market for swaps, which means they are traded by investment specialists like other financial instruments, according to First Boston.
For example, an institution that issues floating-rate debt can transform the floating payments it makes to a fixed-rate assets such as Treasury notes or other fixed-income securities in its portfolio can convert the fixed-rate payments it will receive to a floating rate, which it may want to do if market conditions change and short-term interest rates rise.
Student Loan Marketing Association (Sallie Mae) was one of the first domestic users of interest rate swaps and has been one of the heaviest users of the technique, with transactions exceeding $3 billion in two years. Sallie Mae saved $25.1 million last year by using swaps, a spokeswoman said.
Almost all of Sallie Mae's assets, made up of student loans it purchases and loans it makes to financial institutions, have floating rates. On the liability side, Sallie Mae strives to minimize risk when it borrows money by issuing floating-rate debt so that its assets and liabilities are matched which means they have similar characteristics.
The characteristics Sallie Mae matches to minimize risk are the term or length of its assets and liabilities, and the structure -- either fixed or floating rate.
Before interest rate swaps were invented, Sallie Mae was forced to issue floating-rate debt to raise money to match its floating-rate assets. However, there were times when Sallie Mae could have saved money and avoided using up its floating-rate borrowing capacity if it could have found a way to issue fixed-rate debt when the market was more receptive to that type than to floating-rate debt.
Interest rate swaps provide the technique to save money when Sallie Mae borrows, said Beth Van Houten, a Sallie Mae vice president. "We have lowered our cost of borrowing by taking advantage of opportunities to borrow on a fixed-rate basis and then use interest rate swaps to turn those fixed-rate liabilities into floating-rate liabilities," she said.
Investment bankers act as intermediaries between corporations that wish to swap fixed and floating-rate instruments. First Boston and Salomon Brothers Inc. act both as advisers and principals, which mean they not only advise institutions but also risk their own capital in arranging swaps.
When swaps were invented two years ago, bankers found parties to participate on opposite sides of the transaction and earned a fee for arranging the swap. Increasingly, investment bankers find one party, use their own capital to purchase the swap, and then sell the swap at a later time, creating a liquid secondary market by trading swaps, which means institutions can rapidly enter and exit the market.
The market has become so liquid and use of the technique has become so sophisticated thatmany corporations have provisions in their interest rate swap agreements that allow them to reverse the swap if market conditions change.
"In its simplest form, the swap consists of the exchange by two parties of a series of cash flows representing fixed and floating interest payments," First Boston's Kalvaria said. "It is actually a sophisticated method of arbitraging between different corporate credits, financial instruments and international and domestic capital and money markets. We are playing on various anomalies in the capital markets."
Because only interest payments are traded, a swap is not reflected at all on a company's balance sheet. The savings resulting from the swap will show up on the income statement. In general, financial disclosure rules only require specific reference to swaps in the notes to the financial statements if they materially impact earnings.
First Boston and Salomon Brothers are the leaders among investment banks in arranging swaps and trading them, according to industry experts. First Boston and its European affiliate, Credit Suisse First Boston Ltd., have assisted in completing more than $10 billion in interest rate swaps, company officials said.
Investment banks and commercial banks are battling in the swap market even as the market itself continues to evolve.
Investment banks, led by Salomon and First Boston, want interest rate swaps to become fully tradable so they will not be forced to carry these long-term transactions on their books so they can take advantage of their sophisticated trading operations.Commercial banks, led by Citicorp and Morgan Guaranty, have a competitive advantage in keeping swaps tied to long-term perceptions of credit risk, their principal business.
Salomon Brothers estimates the aggregate size of the interest rate swap market will grow from $3 billion in 1982 when the technique was first used to $70 billion by the end of this year.