Debt Market Distortions Go Global as Nothing Makes Sense Anymore
bloomberg.com
bloomberg.com
Suppose you're a rates dealer. (Rates dealers buy and sell Treasuries and swaps, amongst other things.) An investor wants to invest at the 10-year rate. Say they insist on getting this in the form of a U.S. Treasury. You must either (a) buy a Treasury on the market or (b) pull one from inventory. No other options. Say, on the other hand, they are open to dealing in swaps. You could hedge this like a Treasury. You can also hedge with another swap. Two options instead of one. Makes your life easier, doesn't it?
Dealers always preferred swaps. But investors didn't like taking on the counterparty risk. Dodd-Frank changed that. Now swaps are mutualized. If you take out a swap with JPMorgan and they go kaput, other parties will pool together to make you whole. Less of a difference, in terms of credit quality, between a swap and a Treasury now. Dodd-Frank also made it more expensive to hold Treasuries in inventory.
In summary, swaps were always tastier to dealers. Dodd-Frank made them more attractive to investors. At the same time Treasuries became even less fun for dealers. Left hand meets right hand and you get lower fees on swaps with a commensurate shift in net pricing.
Compare this to before, when swaps were often un-collateralized, so you might have a huge paper profit on a trade that you'll never actually realize because the counterparty lacks the cash to settle up.
So before, you could lose the total amount of your trade, but now you can only lose a day's worth of gain or loss.
This is a big improvement, and the risk to the taxpayer is pretty de minimus. Of course the central clearinghouse could default, but that's very unlikely for a variety of reasons (mostly that the central clearinghouse's whole reason for existence is not to default).
The only way to deliver a Treasury is with a Treasury, which you have to track down out of inventory or from another dealer. You can write a swap without having to go through that ordeal. This means lower transaction costs.
I don't know the mechanics of swap settlement well enough to understand if that is correct, but it seems plausible.
The pricing of a swap didn't first order really reflect credit risk of the swap itself (that effect is small versus what we are discussing here). Because swaps between dealers have long been collateralised with mutual mark to market. It did reflect the fact that LIBOR is rate for an unsecured loan between banks. Possibly the new regime caps how high that might go, but it's really less about LIBOR and more about Treasury funding.
Capital requirements and the higher cost of balance sheet as reflected in the repo market must be a starting point. And that's not just a US thing, but is at work in other markets too.
If you want to understand this, you need to think about what kind of arbitrage trade would profit from this situation and why it's not happening in large enough size to reverse this. You'll realize that the operative constraints are not fears about the creditworthiness of the US government.
Ts are being printed without even the slightest regard for the (old-fashioned) concept known as fiscal rectitude. Swaps can be printed all day long but if the rates start moving you get paid/have-to-pay every 24-hours for the assumed risk. It follows that Ts are now a much riskier bet than swaps, and indeed, what surprises me, is why it has taken so long for this to be happening.
Here's why:
> swaps are through Ts
> IRS is collateralized
> cough LIBOR in order to receive the fixed leg
> majority of swaps receivers
> mark-to-market collateral adjustments
Nobody (to a second order approximation) knows what the fuck any of that means, because, since they are sane people with lives to lead, they don't delve into the details of advanced finance.
On your point about finance being complex. This is Bloomberg writing the story. They of all people should know. And this is the second time in a week that they're pushing this stuff.
BTW: for the average finance guy the CS jargon on this site would also qualify as something to be dismissed by "sane people with lives to lead". Not a valid argument. And before you tell me that this is a CS site so that is understandable, I'll ask you why this Bloomberg stuff is making it to Page 1.
The real story then is that even taking into account this high banking-sector risk, the US government is now riskier. But this has much more to do with the unlimited printing of debt (the real story) than the IRS market swap spread, and my wider point is that daily margining has been ignored by many of the people (here and in the financial markets chatter) who are talking up this issue as some kind of rubicon moment. This has been in the making for years and the slow grind below zero is not something that should be seen as extraordinary, nor, given the aforementioned slow grind lower, should it come as any surprise that it can go negative.
I don't get how U.S. debt is the driving factor. The rate of federal net debt growth has actually been slowing over the past ~3 years as the federal deficit has shrunk, i.e. the arrow is pointed in the right direction.
This might be a makeable case, but just comparing the terms is not enough to do so. And, while he is using it to explain why Treasuries seem to have a risk premium now, it doesn't explain why they did not previously. Did swaps just start being m2M every 24 hours? Certainly there has been no major change to the nature of Treasuries over the past few months. So why the sudden shift?
When you say "Swaps are much more like 24 hour loans" most people (here) will understand you.
Tomorrow a buck is worth about a buck. Given some nice 70s era stagflation, in a decade a buck might only be worth fifty cents. Loaning one dude a buck and getting fifty cents back isn't all that different than loaning out ten dimes and getting only five paid back.
There is also downside risk. Your financial life will be about the same tomorrow as it is today, so I can reasonably estimate the odds of getting a buck back if you need change for the vending machine or whatever. Ten years from now, well, hard to say how many bad things can happen to someone in ten years.
If there's any chance of a treasury default or other disruption, what happens the next day when nobody wants to be left holding the bag? Seems like in a scenario where something is up, daily liquidity is more dangerous.
Basically - we're erasing "normal" counterparty risk in derivatives, in so doing blinding us to big abnormalities. Imagine an ocean with zero waves (ie a pond), until the tidal wave hits. Wouldn't it be better to have some fear of waves hitting you daily, so you're (somewhat more) prepared for "the big one"?
Scarily, there are something like 70 trillion of swap contracts outstanding. Someone correct me if I am wrong (though I'd bet I'm underestimating).
There is a large and growing body of evidence that huge central bank involvement in markets is increasing exactly such risks and it is an extremely important point.
Still... if we consider that you wear the up-to-6 sigma risk with Treasuries (ie 99.999999% of the time - whatever the number of 9s is), but you are spared all but the 6-sigma risks in swaps, then it is probable (though I agree .. not certain), that you're better off with the mark-to-market collateral protection that you get in swaps. Thus the article's main point is erroneous.
It is clear that the idea pushed by Bloomberg here, that banks have somehow become better credit quality than the US government, is wrong, as can be seen by a simple look at their equivalent-maturity borrowing rates in the bond market (well above Treasuries). IE: not comparing apples with oranges.
> Scarily, there are something like 70 trillion of swap contracts outstanding.
I guess there's 15-20T in T's outstanding... if there's 70T in swaps (that don't have a Fed or an army behind them), what would your comment on their 'fiscal rectitude' be?
Swaps != debt.
Swaps do not create a liability/asset unless interest rates move, and even so, most of the swap contracts will then nullify one another.
Most banks admittedly have trillions of notional swaps on their books. The very vast majority of these offset each other. The "open position" (net exposure) in banks is very heavily monitored by the authorities. Banks are not heavily exposed.
Arguably, corporates (who hedge) and insurance companies or pension funds DO have open positions in swaps. But even so, recall that the potential liability is proportional to the likelihood of an interest rate move. Let's say an open position of 1 trillion (enormous) receiver swaps (lent) sees a 3% upmove in 5y interest rates on an average 5y maturity of the book (usually lower). Assuming rates near zero which they are, the duration calculation means a net debt becomes payable by such company of 3x5% = 15% of the notional = 150 billion USD. So 1 trillion became 150 billion, even under an extreme scenario. 1/6th. Then recall, that rates will never move 3% (300bps) in one line. They'll move a few bps every day. It'll be very clear once the liability hits, say 5-10 billion, that the counterparty cannot pay anymore, they will be made bankrupt (or close these positions) well before 3% (remember daily margining?), and the swap contracts will become null and void immediately. So now 1 trillion of swap contracts became 5-10 billion realizable debts.
By contrast, when the Treasury borrows 1 trillion, they owe a full trillion, no matter what happens in interest rates. See the difference?
Now in this analysis, I'm glossing over counterparty risk in swaps. Banks "not heavily exposed" relies on the idea that all banks are good for their commitments, since their netting is done against other banks. This is not the case in a Lehman style scenario(it's like a huge web that even neo4j would have trouble monitoring - ha ha - if a piece of the web falls away, many banks are then potentially exposed). Hence the major focus of all policy makers in the past several years has been to make derivative clearing daily-marginable, and exchange cleared. To erase that problem (outside of 6-sigma "impossible" etc - see one of my other posts)
Further to that policy maker regulation, did you know that in the latest European banking sector rules, derivative contract commitments are senior even to small depositors? So equity goes first, then subordinated (higher yield) debt, then depositors > 100k, then senior debt, then depositors < 100k, and only then, swap liabilities.
Of course, lawyers sit even above swaps ;-)
Generally I did not intend my post to exonerate swaps as a dangerous instrument. They are. Just to say that they cannot be equated with outright debt.
> Why is this so hard for people to understand?
Question answered by earlier sentence in own post. Unless this was a joke?
In swaps, as the word suggests, you must pay (the prevailing short-term interest rate) every few months for the right to receive a pre-agreed (long term) interest rate. The key is that you must pay, and if your counterparty does not pay, you will not pay either. So you have a much lower credit risk than an outright lending of money since if the counterparty starts failing, you can stop paying. Sure there is still some credit risk, but it's nowhere near as high as it would be to lend money for 10 years "naked". And since the crisis, moreover, we have "daily margining", that is, if you win in any 24 hour period, your counterparty must pay your winnings. If he doesn't you can cancel the contract. That's much lower risk than betting on repayment with no feedback, for 10 years.
I'm just generally quite "surprised" that this stuff is coming out of Bloomberg who should know better.
The jargon and tone of your original comment is the reason it is being down voted.
It's also not the case that a UST position is not collateralised. If I sell short 100 mm tens, and I borrow these on the market against cash collateral from my receipt from the sale then if the price drops 10 points I get that back in my bank account - just as with a cleared swap position.
"Nowhere is that more evident than in the U.S., where lending to the government should be far safer than speculating on the direction of interest rates with Wall Street banks."
You aren't "speculating on the direction of interest rates with Wall Street banks", you're buying a synthetic rates position that is centrally cleared with daily variation margin. That's not quite US Treasury safe, but it's pretty damn safe.
Thing is, the game is rigged and when the big players loose, we all pay the bill.
http://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-...