UniCredit, Italy’s largest commercial bank, recently reported that its corporate clients face about $1.4 billion in losses associated with interest rate swaps. The interest rate swaps were sold by the bank to its corporate clients as protection against raising interest rates. 

The interest rate swaps work this way. A corporate client borrows on a floating rate basis, then swaps the floating rate for a fixed rate over the life of the loan. It locks in its interest expense by doing so, and all is well. But the corporate client doesn’t necessarily feel so well if interest rates fall instead of rise. After all, if interest rates fall, the corporate client would be better off paying interest expense on a floating rate basis rather than on a higher fixed rate basis.

The interest rate swaps that have resulted in the cumulative $1.4 billion in losses go back over a period of years. Further, they represent losses when measured against what might have been, i.e., when measured against interest expense if the corporate clients had retained their floating rate basis. Nonetheless, the losses are particularly irksome since the corporate clients’ financial advisor – UniCredit – suggested it was in their best interest to buy the swaps. UniCredit, of course, earned a commission from all interest rate swaps it sold to its client base.

More than 50 lawsuits have been filed by corporate clients. Of those resolved, the bank has lost six. The complaints continue to mount.

Derivatives, as we all know, can be a bit tricky. They are simply contracts whose value is determined by – or derived from – the value of another security, index, commodity, or interest rate, for example. The sub prime credit crisis in the U.S. is a derivative crisis. The risk and associated market value of mortgage-backed securities derives from the underlying value of individual residential mortgages. As the risk of those underlying residential mortgages increases in the face of rising delinquencies and defaults, the market value of the associated derivative decreases – and may decrease quite dramatically as we’ve seen.

In a recent edition of the International Herald Tribune, there were five especially interesting articles in the business section.  The first four to meet your eye are listed below.

• “Tight credit roils European property market”
• “Expected loan turmoil to last, Citibank says”
• “3 banks creating a fund to buy shunned debt”
• “Japanese casualty of U.S. credit woes”

The U.S. sub prime credit crisis seems here to stay for awhile, if the thrust of the articles is correct.  Moreover, the crisis has cast a fairly wide net, reaching outside the U.S. markets to impact Europe and Japan directly and adversely.

The fifth article – “A Spanish bank keeps risks under control” – had a related but very different focus and message.  BBVA, headquartered in the Guggenheim Museum city of Bilbao in the Spanish Basque country, ranks 22nd in the world in terms of its market capitalization.  It has one of the lowest non-performing loan ratios within the top 25 at 0.86%.  Its return on equity is among the highest at 36.4% with current annualized growth of roughly 20%.

Interestingly, the bank has no exposure to sub prime loans or leverage buyouts.  It is a major player in the global remittances market and a top pension fund manager in Latin America.  Its wholesale banking division, which had record revenues in July and August, focuses on stable, recurring business – rather pedestrian in today’s world of exotic financial instruments and the associated penetration into previously unbankable markets.

It’s heartening to learn that financial institutions can still succeed the old fashioned way…and succeed quite well at that.

The sub prime credit crisis and its impact on the U.S. economy is as newsworthy in Europe as it is in the U.S.  But the focus is different in one interesting respect.  Europe is highly attuned to the impact of the crisis on domestic spending in the U.S. and the ripple effect on  the resulting U.S. trade imbalance.  The massive U.S. trade deficit is widely considered in Europe, and elsewhere, as one of the most dangerous threats to global economic equilibrium.

The sub prime credit crisis has also contributed to the continuing fall of the dollar against the Euro and other foreign currencies, which has tended to inhibit imports and further limit consumption while stimulating U.S. exports.  In fact, as recently released statistics indicate, the U.S. trade deficit in July fell to its lowest level since January 2007.  U. S. exports reached an historic high.

By some estimates, the increase in exports has added about 0.5% to gross domestic product over the past year, which partially offsets the 0.9% decrease attributed to events in the housing market over that same period.  So while our focus in the U.S. is very much on domestic consumer spending in the unfolding aftermath of the housing and sub prime credit crises, we need to keep in mind that there is a foreign dimension to the economy, which is presently exerting a beneficial impact on the course of events.