Question/Topic for Finance Professional: Swaps or Notional Principal Contracts

[Fern]

The term "notional principal contract" seems to be a tax law term. I.e., you guys may use a different term.

Here's a quick definition for those like me who aren't too familiar with notional principal contracts:

Principal balance underlying a Swap transaction, and the amount used to compute swap payments in an Interest Rate Swap or Currency Swap. Once the obligation to pay interest is separated from the principal on the underlying security, it becomes a notional amount, and is the fictitious principal generating the cash flows in a swap agreement. The two parties to a swap agreement trade the cash flow yield, not the notional amount. Interest payments accrue as with any ordinary interest-bearing security, even though the investor in fact receives only interest payments.

http://www.answers.com/topic/notional-principal

I am now seeing clients engage in (large) loans with swap features (notional principal contracts) to purchase commercial real estate projects. This is a new topic for me and I have some questions, and an observation:

It seems to me the lending bank is engaging in a 'bet' of sorts. As long as the LIBOR rate remains below the borrower's fixed rate the bank profits. However, should the LIBOR rise to exceed that fixed rate it seems to me the bank loses money. Is that correct?

Looking at the pdf on the this site (The Congressional Joint Committee of Taxation) it appears that swaps/notional principal contracts are still growing rapidly. Is that correct in your estimation? https://www.jct.gov/publications.html?func=startdown&id=4372 (see page 6 of the pdf for the chart I'm referring to.)

Aren't these the exact thing, or at least a form of it, that caused the recent financial meltdown?

If these are essentially a bet by banks and they have risk, are we setting ourselves up for another bubble that could burst and more 'too big to fail' should interest rates rise significantly?

TIA

Fern

 

[LegendKiller]

In most cases the banks writing the swap lay off the contract to other banks, ultimately somebody IS taking the risk, however, the differential isn't huge and the amount of crossing that happens is pretty large.