Another Misuse of Financial Derivatives

Just like any financial derivatives that were initially designed for risk management purposes, interest rate swaps are an effective tool for managing and transferring interest rate risks as long as those risks are well understood. But as banks and financial institutions are constantly trying to invent new financial products to sell to their consumers, sometimes the risks of those products are not well understood and disclosed.

This is what happened with the interest rate swap market in New Zealand where banks sold interest rate swaps to farmers in order for them to hedge the fluctuation in the mortgage rates. However, the banks only emphasized the advantages of the interest rate swaps, and they did not discuss the potential downside in detail.

Swaps are enormously complicated and risky financial derivatives. They are used – mostly by big businesses or international dealing rooms – to hedge against interest rate moves.

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But in the period 2005-2008, New Zealand banks aggressively sold swaps to farmers as a supposedly less risky alternative to fixed interest loans, and a way for farmers to protect themselves from hikes in their mortgage repayments if interest rates went up.

When the financial crisis hit, and the interest rates went down, farmers started losing money. Many were forced to sell their farms, and some of them committed suicide.

Walker estimates up to 2000 New Zealand farmers lost up to $1 billion on swaps. They lost farms they had inherited from their fathers and planned to pass onto their children. Too many committed suicide. Walker spent the three years following the Farmers Weekly survey doggedly researching banks’ sales of swaps to New Zealand farmers. And then she went to see the regulators. Read more

The problem is not in the financial derivative itself, but it is that the risks were not well understood and explained to the customers.

Banks will be asking what are the lessons, what do we need to change to make sure going forward we don’t have this happen with a different product. It’s not so much just about the swaps but how do we make this not happen in the future.