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Guest Post: Hedge Funds Turn Down Free Money And Other Implications Of Negative Swap Spreads
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Isn't this simply, default?
It's default but not yet.
It's like time bomb. It's bomb but not till timer says it's bomb.
Isn't this simply, default?
Japan is good example of constantly negative (rather positive, as they quote other way around) swap spreads. There are few reasons, some fundamentals and some related to dynamic of the market.
1. Fundamental. Spreads are function of interest rates. Higher rates - wide spreads. Thats biggest driver IMHO, as rates move up - spreads will and do widen.
2. Fundamental. Japan low credit rating AA2 vs AAA as it should be, as result asset swaped in US$ need to be $L+ not -.
3. Fundamental. Kind of see num 1, but add XCCY swap curve on top of it. As international buyers look at $L level not at JPYL
4. Supply/demand. Insurance companies stay away from 30y sector as its too long for duration matching they need to do
5. Supply/demand. Structure product issuance (kind of similiar to MBS flow in US). They short convexity guys and as rates go low and yen stronger, they need to rec 30y
Thats about it. Cheers
But the point remains this.
If swap spreads are negative, then someone borrow at LIBOR and buy bonds. Fund the borrowing costs wit the coupon and pocket the diff.
If this is the natural course of things, why wouldn't somebidy arb it !?!
2 reason: 1. Spreads are directional. its arb when its 2yr paper, and bet on higher rates when its 30y paper. 2a Repo haircut on long dated bonds (even UST), make bond borrowing not as easy as it looks for lever guys. 2b For unlever accounts, 30y bond is balance sheet intensive transaction, and nobody has balance sheet now days. BTW on the issue of ARB. 30y is too long time to arb anything. been long 30y spreads in Japan was trade that blew Meriwether 2 times. Once as LTCM and second as JWM in 2008.
Agree totally with 2a and 2b. It's a new world.
And thanks for the LTCM and JWM perspective and testing my ideas. I see your point about a 30 yr long blowing up a swap arb.
There is no other place to get this kind of feedback other than this site.
funny part is that in old good days biggest buyers of 30y ASW in $L, been German Banks and Swiss Pensions. They secure $L+40 (via XCCY) and funded themself at $L-20 due to their good old Bundesbank Backing. Then everything went haywire EMU came into play and this bid disapear forever... Its stabilized at YenL+20 and LTCM pushed it down to YenL-10 Then they blow up, it went to YebL+30 then it went all way down then lever guys come in and pushed it to JPYL-20 then 2008 came they all blew up and now its YenL+10 or so, and no bids. But levers guys will be back one day. They never learn...
Been wondering about this for a long time myself. Think most of it is the capital efficiency argument combined with long duration demand from pension funds and insurance companies. I do not think they can repo Treasuries. The mortgage market can have an impact in the 5/7 and 10 yr spreads but little if anything related to 30 yr spreads.
I agree it's not all MBS hedging. This is bigger than the US, so MBS hedging can't be the only story.
I noticed this for 20 yr Gilts myself. Another poster said it was common in Japan.
What is a swap worth if you believe the counterparty will renege on it if the trade goes your way?
Most swaps have no coutnerparty risk due to the clearing and settlement system.
What if the clearing and settlement system is broken and you are being lied to.
Would anyone be shocked to learn that quoted LIBOR understates the actual interbank offered rate? As the article says, when manipulation of every single facet of markets becomes a tool of public policy, then the market prices are meaningless. Trying to make sense of broken relationships in this environment is futile, other than to suggest that the unwind will be very violent.
MATT TAIBBI has a great article, if you haven't already read it.
Wall Street's Bailout Hustle
http://www.rollingstone.com/politics/story/32255149/wall_streets_bailout...
A great history of con artists and their bag of cons, taken to unknown levels, unseen or imagined before, by the banksters and government enablers at our expense.
With a tag like "free money" I half expect to see this guy.
there are a couple of other things going on also. Pension funds in the UK use Liability Driven Investment strategies that make heavy use of RPI swaps. These are one sided trades and pension funds (although some have done recently) as a rule pay up big for inflation proofed hedging. The other issue is that you have to reverse engineer two things. One is that the market that is hot and growing is sovereign CDS, so you have to factor in the players driving prices here and compare with the fap between swaps and physical govies, the other is that your analogy of AA rates as a proxy is flawed. The P/L of a swap is collateralised with a haircut, so it is effectively triple A, with no counterparty risk, only novation risk. It is the novation risk that is the issue, guys migrating out of Lehman swaps paid beyond the collateral haricuts when the market liquidity (confidence in banking system) ceased. I have an issue with the unlimited size of the swap market being secured on collateral. The Fed has been accpeting any crap as collateral, but the market has'nt. Similarly the sheers size of the collateral used in the swap market is the tinder box. We know that when markets fail, the profit you thought you with a failed counterparty ceases to exist if the collateral doesn't cover novation PLUS you have the counterparty in loss also so its double down time. Secondly, when you get big market swings (like a return to an unrigged interest rate environment and normal GDP/CPI) there simply isnt enough collateral available to back the P/L. Come to think of it, where is all the collateral currently coming from? I think you will find that there isn't sufficient to cover a 3% swing in a 600 trillion dollar market, there simply arent enough bonds on issue, even if every bond was being sequestered from investors who didnt want to collateralise.repo their bonds. So, the collateral is now more value than the swap business being written. I like the article though, it is good to kick the tyres.
its interesting. Are you sure that plain-vanila IRS are collaterillized? Unless there is notional exchange(as in case of XCCY) there is no collateral. Not in interbank market. not for lever guys. not for corporates. As most swaps don't have much credit risk. Say u do 100m with S/A 3% coupon. Your credit exposure is NOT on 100m, its always < 1.5M (depends how much accrural from today to next payment). So there is very little need for collateral, at least in IRS market. However, daily margining and haircut widely used for smaller players.
CDS werent collateralised and settlements were outstanding for up to 6 months post deal date prior to 2008. Most of this was inter dealer trading. IRS have been collateralised with a switch from weekly to daily collateral posting being the norm in the last year or so. Many swap counterparties have been taking only tbills as collateral and refusing cash. But securities are being used too. This shows that every aspect of a swap must work on time without prejudice and highlights that counterparty risk is not restricted to fair pricing, but also settlement systems/methods. I await anyone who knows better about actual posting of bank collateral these days. Happy to learn of changes etc between different countries/ISDA interpretations for umbrella swaps or single name swaps agreements.
you point is well made and one I wanted to emphasise also..its the P/L that is collateralised for non-banks. I am not sure what the majorbanks do with each other and how this relates to "lack of liquidity" in interbank markets.
damn...posted a thought piece and i wasnt signed in AND i didnt copy it! grrrr...test
nope..bloody thing.
Points were,
1. You have to reverse engineer what goes on in a swap as you have done, but you need to include collateral. Swaps are collateralised (with a haircut) so are a better risk than sovereigns who we all know are not AAA, in the same way we now know mortgage pools were never AAA (Superbowl, the Who, we wont get burned again!). Ratings agencies are as full of shit about sovereign risk as they were about ABS risk, so why would you even mention them as an authority on the credit risk of sovereigns?
2. In the UK, pension funds are not traders of inflation linked swaps, they only go long protection. so why not rip their faces off while the going is good, until the final natural seller of that risk appears. This isn't small beans, given that UK pension funds have around £2-3 trillion in liabilities (and a deficit of some £150 billion in what they owe to soon to be pensioners) it takes around 1,500 trades to actually clear a market to find a natural seller of this risk via all the financial engineering that goes on in what passes for global capital markets. The final side of the UK pension fund business is probably infrastructure inflation risk in the Two Gorges damn in China or the rape of the Brazilian rain forest. The market will have to find a natural seller of risk into the $25 trillion of Medicare/Medicaid soon enough. (Desalination plants for 12 billion people anyone?).
3. The real tinder box is collateral. The con is that it simply doesn't exist in sufficient volume to support the demands of a 5% swing in price in interest rate markets. That's not yield, thats price, so c. 0.5% rise in ten year bond yields. No doubt the fact that the Fed has taken on the entire mortgage market over the last year and the Government via Fraudy and Funny own the collateral of 60% of the entire mortgage market. Let's do the maths. The derivative market (including CDS) is unlimited. This is not like off course betting at a horse race, where betters settle up once the race is over. The race is never over. The outstanding swaps market is what $60 trillion? $600 trillion? take a 5% movement in p/l..the shuffle around means that collateral worth 3 or 30 trillion must be stumped up. There isnt that much liquid collateral around for delivery, so the takers of collateral either have to give it back or the system fails. If its given back then, as with Lehmans, the loss is doubled down. The profit disappears because the other side fails completely. Remember it was collateral calls that collapsed AIG (with Goldmans bullying SocGen to take volume when it wanted it to). Collateral is value and its been overpledged. In other words..you dont have collateral at all if the market actually moves.
4. You might there must be a relationship between Sovereign CDS and the spread between Government bonds and swap yields. Any increase in spread must push the swap further through the government yield curve. Forget the rating agencies, this is the arb that hedge funds are missing, or then again, maybe they arent and simply take five times the swap risk for one times the Sovereign CDS risk..
5. Finally, CDS are an option. The other arb is via swaptions and options on Government bonds. Since options are priced on volatility, watch this space for a boom by hedge funds in non-linear pay-offs via options as regulators clamp down on CDS usage and arbers go to real arb. Have you checked out the pricing of an option on a 5 x 5 year forward versus the Sovereign CDS and the option on a ten year treasury?
Great thought piece tho. Glad someone is at least asking the questions!
You gave away your pedigree (tyres).
You sparked something with the "where is the collateral" point, and it explains a lot, combined with another poster's points.
The world isn't just liquidity starved, it is collateral starved.
No collateral, no leverage. No leverage, no arb.
IMHO, CDS is hot, but it is peanuts compared to the swap market, and probaly always will be. It is hot because you really rake in money on a CDS position... I'm not going any further than that. But if you accept that statement as true, then what limited collateral you have on bal sheet is gonna go there, not in plain-jane 30yr swaps.
Cheerio, bro.
three gorges dam
ack!!! sorry guys, i now know that anonymous posts take ten minutes to clear, but they do clear..anyways..the second one was better :)
As you may have been from the Bloomberg News story dispatched to you previously today,(http://www.gata.org/node/8352), Federal Reserve Chairman Ben Bernanke is to appear next week before the banking committees of Congress to present the Fed's semi-annual report on the economy. Presumably Bernanke will be subjected to the usual questioning by committee members. The problem, of course, is that these questions are seldom very compelling and so elicit little about the Fed's secret, market-manipulating actions.
With your help, we can change that next week.
After all, what if a committee member asked Bernanke about the Fed's gold swap agreements with foreign banks, agreements the Fed admits having and insists on keeping secret, agreements about which GATA is suing the Fed for access under the U.S. Freedom of Information Act?
Of course Bernanke might weave, dodge, and evade such questions, but then the issue would be squarely on the table.
These are the key questions for Bernanke:
1) Will you confirm the substance of Fed Governor Kevin M. Warsh's letter of September 17, 2009, to the Gold Anti-Trust Action Committee, to the effect that the Fed has gold swap agreements with foreign banks and insists on keeping those agreements secret? (For a copy of Warsh's letter, see http://www.gata.org/node/8192.)
2) What is the purpose of the Fed's gold swap agreements?
3) Have any of these agreements ever been implemented? If so, exactly how, why, and when?
4) How do those agreements affect the U.S. gold reserves?
5) Why must the Fed keep these agreements secret? What would happen if the public, the markets, and Congress knew what the Fed was doing in the gold market? Will the Fed disclose those agreements to Congress? If not, why?
If you're a U.S. citizen, you can help put these questions to Bernanke and thus hasten the end of the gold price suppression scheme by urgently contacting your U.S. representative and U.S. senators and ask them to see that Bernanke is asked about the gold swaps. You especially can help if your U.S. representative or either of your U.S. senators is a member of the House Financial Services Committee or the Senate Committee on Banking, Housing, and Urban Affairs, the committees that will question Bernanke directly.
You can find a list of members of the House Financial Services Committee here:
http://financialservices.house.gov/members.html
A list of the members of the Senate Banking Committee is here:
http://banking.senate.gov/public/index.cfm?FuseAction=CommitteeInformati...
You can identify and locate your U.S. representative here:
http://www.house.gov/
You can identify and locate your U.S. senators here:
http://www.senate.gov/
For this to have a chance with Bernanke's testimony next week, you'll have to try to reach your U.S. representative and senators on Monday. Please do try. All it will take is one member of Congress to raise the issue during the hearings. Thanks for your help.
dude you got to be kidding? there are 1,000 gold threads to post this one. Why it has to be here? People try to have some talk about something that has nothing to do with yellow shiny stuff. GO AWAY!
there is nothing in finance, that is not affected by the gold price suppression
Maybe, but give it a rest is all. Moves by super-powerful entities in giant, worldwide markets all affect other markets.
There are about 10 articles per day about gold on ZH, and those of us who haven't mortgaged our futures against the speculation that The Great Reset is a foregone conclusion like to see something other than ranting about this one commodity all day every day.
YOU SHALL NOT PASS! BACK TO GATA WITH YOU...
YOU GOLDBUG CRAZIES ARE THE CANCER THAT IS KILLING ZERO HEDGE
Could it be as simple as this: 30 year swap spreads went negative right around when Lehman went bankrupt. Swap spreads are tied to LIBOR and LIBOR is about unsecured loans. Nobody wants to borrow unsecured anymore.
Excuse my simplistic thinking.
LIBOR is the rate certain banks say that they charge each other. In other words, it is used by a bank that doesn't have sufficient cash today to fund its daily settlements. The bank funds itself over a term, usually up to 15 months. Term funding allows a nuance to develop to match theborrowings banks expected repayment from who who it has on lent the money tom by borrowing at o/n 7 day 3month or up to 15 month LIBOR. SWAPS are what banks use to switch one type of funding for another for longer periods. So a bank can provide a facility to a customer (which could be another bank) that switches (usually) fixed for floating rate funding (IRS). The floating rate is at 90 or 180 day LIBOR. The swap starts with zero cash changing hands, but the duration of the fixed leg (say for a ten year swap) varies according to its duration, creating p/l which the loser has to put up collateral for. This collateral has a "haircut" with morebeing used for crappier rated paper. If yield go up by 1% on a zero coupon ten year swap, then the receiver of fixed rate funds loses 1% x 10 years = 10% and must put up collateral of a little in excess of this loss. This collateral is either owned already or must be borrowed from someone else. This is a systemic shock. A subsequent post says that IRS is vastly larger than the sovereign CDS market. I've replied to that one too. Swaps are valued by price makers (banks) who have got too bigger to fail and the number of banks active in the market has dropped also. So you have the issue of a 60 trillion dollar market being priced by half a dozen instead of 50 marker makers pricing up where they MIGHT trade 3, 5 or 10 year IRS for example in a size of $25m. thats pricing volume of 6x 25 million pricing 60 trillion. Not good! Hope this helps.
your right but few points.
1. its call margining, as it works same way as futures, collateralization is slightly different process,is when I put up my notional, and as you rightly stated, there is NO notional exchange. Also, all interbank market doesn't need any margining, as well as big corporate and big HFs. Only small guys need margining and even small guys have some sort of global netting with their PB...
2. Example of Zero coupon swaps is not correct one. Zero coupon and off-market swaps considered to be a loan, and they indeed very often collaterlized and very different set of rules apply to these animals. FSA or whoever your regulators are, will come very hard on these type of transaction, so there are very few.
2. Building Zero Curve and disounting cash flow is such a trivial process now days that any middle school graduate with basic excel skill shoud be able to price IRS, so control is not a big deal
Cheers
Cheers
I must express my gratitude here, you provide an invaluable service Messrs. Anonymous internet people...
This thread is about risk management. I was intrigued by Order6102's comments until he went out of his way to deride the goldbug. None of us have a monopoly on what's postworthy and what's not, nor should we act in such a manner.
Agreed he could have found a better thread, now i'm wasting my time much as you guys wasted yours telling him to post elsewhere.
Better luck next time to each of us.
Few more thoughts. There are fewer banks pricing a larger pot as swaps volume (although netted off a year ago in big volume) is priced by fewer banks. So 6 banks price 40 trillion still unnetted, against 25 banks pricing 60 trillion a year ago. The evidence of even too bigger to fail is apparent in pricing. This is vested interest and control. Sovereigns and central banks should be increasing participation in pricing of swaps and usage, or limiting market size to a function of Tier 1 capital, pick a number like what would a 5% adverse price movement over a month have on a banks swap book, then have that down as a Tier 1 capital requirement, same as you would do for loans and other risk. I dont see this being done anywhere. Also the volatility of Sovereign CDS is now high, leave aside selling vol on Sov CDS (sounds like a good idea to me since Sovereigns can rig their own market) so you have to match the vol of Sov CDS with 20 times the volume of Swaps. You then need 20 times the volume of collateral in the Swap compared to the Sov CDS. Turn it round the other way, Sov CDS are a leverage play in proportion to the vol of the spread in sov CDS ( I reckon 20 times for now, but thats because there are big swinging dicks who have to create heat to game the system).
Affirm. Your thoughts in a sense make a case for an arb here if the big swinging push sov CDS too hard.
There is a possibility it could be regulated out of commission. That money's gotta work somewhere,and it would likely flow to an established product.
The Fed is expanding the number of primary dealers, Scotia, etc. These are natural candidates to step into IRS.
i thnk CDS market is very different animal then IRS. ASW priced against vanila IRS , as result I don't think CDS has any implication on domestic ASW market. By the end of the day even Zimbabwe Govt is AAA rated in local currency...
theres that rating again,! good posts order6102, i am trying not to get into the significance of i spreads asw z's etc.and the implications there..since i have forgotten all about them since bid/offers widened. I think you will agree that if zim is AAA local that is not a correct measure of creditworthiness. ( I thought it was a lot lower and that even local currency ratings are not all AAA anyway?) Getting ready for the next purple swan, looks to me like it will be the version of default that sov CDS are trying to capture. Governments dont default..ever, long as they arentinvaded, its how much in the dollar you get back on restructuring once the IMF has royally screwed the country over. The new player is China who will offer better terms than the IMF and therefore wont bankrupt a country that is already in trouble. I am not sure of the impact of this on global capital markets yet. Still thinking about it. Our markets will have to adapt to the new playground bully on the block and find ways to avoid his rules and lunch money grabs so he can protect his syndicate (military junta). Anyway...
I 100% agree, AAA on-shore rating doesn't mean much. However so far we went thru Asian Crisis and during it, IRS ASW did basicaly nothing, while XCCY ASW ($L) exploded. So from what we know so far, that ASW doesn't hold any credit component directly, even in times of massive blow ups. But its gets affected by $L buyers of local paper, as been in case of Japan. I have nothing to add about CDS market - never done it.
JM i am still amazed at how few players there are left making prices in waps, canadian/oz banks might be new players..Nomura is building out too..with Lehmans old dealing platforms..but still...6 players? ack..should be 26
i am not familiar with US swap market. How about guys liek WFC, BONNY and such? do they make markets?
However what i know for sure that in Asian time zone, big 3 japanese have USD Swap desks. Almost all banks in HK make markets in USD Swaps (due to peg).
there are banks who make prices in smaller volumes, and IRS is the most liquid..but check out total return swaps by portable alpha managers as an indication of underlying volume..down to 2 in europe (from 7) WFC andthe custody banks like NT, SSgA, BNY Mellon, dont. Have to think about whether the major players like RBS, JPM, DB will just quietly scale back as well. Leave it to GS to clean up. God knows what BoA and their UK poodle Barclays will be doing in a year. The loan books of the largest banks have swaps written against I would think and they are trying every trick in the book to get rid of them, so may have to either unwind swaps or run them down, (loans are floating so presumably they were receivers of this and will be payers of floating just when q/e ends, so the yield curve slope will be themajor risk for them). I dont think Barclays financing the off balance sheeting for now of its gimongous loan book to the cayman islands and payment of multi-million dollar salaries to key risk staff via preferential financing has been copied much. But global banks have way too many loans that just dont perform and were fraudlently/slackly written.
There are far more market makers in USD interest rate swaps/swaptions than six. The following U.S. entities are "market makers" in some manner: Goldman, JPM, Morgan Stanley, BofA, WFC, BoNY, Citibank, Sun Trust, Regions and Jeffries. Furthermore, there are many smaller regionals that have swaps desks where they largely back-to-back their risks with larger dealers but may retain some residual risk. There are also several "regional dealers" that have desks or are contemplating them.
Foreign banks that make markets in USD swaps/swaptions include: Barclays, BNP, RBS, UBS, CSFB, Standard Chartered, Nomura, Soc Gen, Calyon, Mizuho, Bank Of Tokyo, RBC, Bank Of Nova Scotia.
In short, some of the posts here are not correct in their understanding of the players in the USD swap market and how it functions.
For example, the market is largely collateralized. That said, several posters made the point about how a big rate move might make meeting margin calls somewhat difficult for players. But you also have to factor in what the net overall positions are between counterparties and across the whole market. There are only two directions swap counterparties can trade - pay fixed (i.e. short the rates market) or receive fixed (i.e. long the rates market) and the exposures generated between counterparties are netted down (i.e. if counterparty A has four swaps on with Counterparty B, they can net the exposures down to the extent that each counterparty is a payer of fixed). So the net exposure across the entire swap market universe is smaller than it would otherwise appear.
That said, this is a great topic and thread (excepting the goldbug crazies). Thank you ZH and posters.
It is important to note the point of netting and not notional. But I think the "collateral problem" discussed, if I may call it such, is that the market is so big that even after netting we could be talking about trillions in negative exposures.
That swap spreads are negative seems to indicate that there are liquidity/collateral issues in play, no?
How else can it be explained?
The problem with appealing to collateral issues is that it is only 30 year swaps spreads that are negative. Liquidity in the long bond is also very poor, which would typically make it cheap rather than expensive.
Some other culprits, courtesy of a tip I got:
http://acrossthecurve.com/?p=8933
http://www.risk.net/risk-magazine/news/1589083/banks-pull-prdc-market
There are far more market makers in USD interest rate swaps/swaptions than six. The following U.S. entities are "market makers" in some manner: Goldman, JPM, Morgan Stanley, BofA, WFC, BoNY, Citibank, Sun Trust, Regions and Jeffries. Furthermore, there are many smaller regionals that have swaps desks where they largely back-to-back their risks with larger dealers but may retain some residual risk. There are also several "regional dealers" that have desks or are contemplating them.
Foreign banks that make markets in USD swaps/swaptions include: Barclays, BNP, RBS, UBS, CSFB, Standard Chartered, Nomura, Soc Gen, Calyon, Mizuho, Bank Of Tokyo, RBC, Bank Of Nova Scotia.
In short, some of the posts here are not correct in their understanding of the players in the USD swap market and how it functions.
For example, the market is largely collateralized. That said, several posters made the point about how a big rate move might make meeting margin calls somewhat difficult for players. But you also have to factor in what the net overall positions are between counterparties and across the whole market. There are only two directions swap counterparties can trade - pay fixed (i.e. short the rates market) or receive fixed (i.e. long the rates market) and the exposures generated between counterparties are netted down (i.e. if counterparty A has four swaps on with Counterparty B, they can net the exposures down to the extent that each counterparty is a payer of fixed). So the net exposure across the entire swap market universe is smaller than it would otherwise appear.
That said, this is a great topic and thread (excepting the goldbug crazies). Thank you ZH and posters.
Nice article and wonderfully educational discussion, thanks!
The 30 yr swap spread chart in the pdf seems to correspond nicely with changes in investor confidence in the long-term prospects of the US economy. Seems to indicate that we are presently at the turning point.
When bill yields went negative, it was thought to be a centennial event. And then it happened twice more, and everyone just sort of accepted it. Strange days, these. Further discourse on this odd state of affairs will be very much appreciated!
On bills. When the system is in meltdown, people want nanosecond maturity on the yield curve.
For a historical take, see:
http://www.zerohedge.com/article/guest-post-par-value-during-black-plague-treasuries-are-financial-teflon-silver-makes-pretty
Thanks 239287, I should have been more specific in my count of swap players to state "significant" swap players. I haven't got the data tohandon this laptop, but I recall from BIS numbers (which aren't perfect) earlier this year or late last year that showed the top 5 swap players have a "significant" slice of the market, i.e. 90% or so. I agree that swaps are collateralised and collateral requirements can be netted. This gets down to a swap duration VaR per bank and whether bank can access sufficient collateral AND whether this netted position should be reflected in Tier 1 capital adequacy. Not sure whether this is the same game that Greece played, but I think it could be.
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