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For Those About To Swap (We Salute You), Submitted by JM
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That reminds me. Can you have Marla spin tonight? Thanks in advance
Actually... "Dirty Deeds, Done Dirt Cheap!!!!"
That brought such a laugh, the header. Awesome TD.
And SloSquez's follow-up, priceless.
Great start to my morning, gracias gentlemen!
maybe this should be sub-titled...WWLSD?
what would larry summers do...after that sizable trade for Harvard Management Co. went sizably wrong. (They've since unwound that puppy, which at the time of unwind had ~ 18yr cf duration remaining on a pay-fixed.)
It is only presumption to claim understanding of the slurring, shifty-eyed bowel impaction that is Larry the Hutt.
However, I believe he would take great pride in his unique discredit to a once-hallowed institution. Then he would drop strawberries in his champagne cocktail and watch the unwind implosions through the glass.
If he could see through the anti-psychotics and heavy sedation, he would perceive millions of (one-fingered) salutes in his direction.
Great work Tyler,
Somewhere in the dark recesses of my mind, I remember like kind exchanges. Many moons ago I did lots of corporate tax returns, but that's not what this is about, is it? As Michael Milkin said, liquidity is always an illusion. It's alway there until you need it. Such is life.
I do not believe that Section 1231 Like-kind exchanges work for a financial instrument such as a swap.
The counterparty risk and the trust your counterparty until you need an iron fist got me thinking. Nobody trusts a counterparty, that's why there is collateral posted against p/l on the swap. Most all ISDA's have minimum credit quality/ratings set at A+ that will trigger novation of the swap, but perhaps not for short term swaps.
The short term tilt of the swaps got me thinking too. Participants are expressing either a utility function or an interest rate view.
Then I factored in that CDS insure against default and can protection can be bought against counterparties but these are not collateral, they are insurance for the term of the CDS and (assuming the CDS market is permanent) 6 x 5 year CDS can insure for default for 30 years.
I like the play to insure against market risk. LIBOR/OIS hedging, taking views on curve shape and direction. I am not sure that the transfer of wealth from those that have been bailed out in the banking/insurance sector or who have participated fully in the government subsidy from the Fed and the Treasury (at the permanent expense of the taxpayers long term standard of living) has been adequately captured. When the system implodes from a steady drain on those bailed out institutions back to the tax payer, for, say 50 cents in the dollar of subsidy given, to return taxpayers living standards to, say 3/4 of what it was, this will be evidenced by a fair return on capital. This fair return is somewhere between 3 and 6% for cash and 5 and 8% for Government bonds depending on duration. I am now going to re-re-read the top down stats and think some more, but this may take a while! heh
Yeah, SwapClear takes care of a lot of troubles, but ultimately if you are big on the losing side, there are conditions where it would be desirable to unwind you positions. It would pretty much require up-front capital unless you were OK with being sloppy in setting up your offsetting swap, which may often be the case.
I'm not so convinced we'll have a nasty IRS rout, rather even moderate unwinding in IRS would look like a coming illiquidity hurricane in its impact on markets of lesser size.
Imagine this is going on as, say, the Fed drains liquidity. Talk about a perfect storm.
I'm not blaming CDS for the problems of governments right now, but they perceived as an increasingly belligerent threat to sovereigns. At the same time, you can't turn back time. Not sure what their future holds there.
Maybe in some dystopian future there will be CDS traders domiciled in renegade states. Hmmm... a guest post from the future...
"Most all ISDA's have minimum credit quality/ratings set at A+ that will trigger novation of the swap, but perhaps not for short term swaps."
This applies (applied) to many SPVs but not to the wider market.
So the banks are typically on the floating-paying leg of these transactions - or do they just broker the deal between two non-bank parties?
There has to be a way to ease out of ZIRP if most swaps are < 1 yr if you raise rates slowly enough. What happened in 2000 when the curve inverted? Was the market much smaller then?
It looks like they have more exposure on the float leg but the sheer size of the market indicates that there are off-setting positions on the fixed leg.
There is about $10 trillion in net exposure according to BIS (off my head), but there are no stats on the maturity. So I won't claim to know what the exposures actually reduce to, other than they are still big.
Easing out: nobody wanted LIBOR-OIS to explode in late 2008, but it was too big to control. Not sure that even the Fed can credibly backstop the interbank market/subsidize LIBOR-LIBID rates for any sustained time.
In 2000, the swap market was a different animal in size and structure. MtM wasn't done as frequently now, and it was a fraction compared to nowadays. Not as much liquidity to sop up?
Is any analysis possible of the extent to which netting is non-uniform, unevenly spread? Does anyone even know what counterparties have what amounts of exposure to moves in either direction? Everything works until a counterparty cannot perform, and at that point ALL swaps with that counterparty become worthless, don't they? Wouldn't loss of a significant counterparty (or even an insignificant one) then cascade through the system?
Am I missing something?
What is more important IMHO is the composition of collateral and the extent of collateral rehypothecation.
These instruments are transacted and settled through a central clearing house, and the house sets the rules. SwapClear runs well, and IRS have no explicit counterparty risk. If a counterparty doesn't perform, the other party is made whole through collateral and SwapClear netting.
What risk they carry is more indicative of the system failure risk that every asset carries with it.
Well, here's my point: banks can collect collateral, but if there is a general breakdown in the economy the collateral won't be worth what it was purported to be, so there is a threat to hypothecation. However, the banks have regulatory blessing to carry assets on their books at whatever marks they wish, AND they have the backing of an unlimited printing press (unlike the counties and states from whom they'll be seizing assets in court, all legal-like), so the banks will always win, won't they? The banks' counterparties will have to tell the truth and abide by the agreements, but the banks never do. This means the banks end up owning everything under fradulent circumstances, and now, for example, rather than paying their county for water, they pay some bank. I understand why the banks would like this, but the banks must understand why I do not.
I don't disagree in principle with your chief point... that monetization and recapitalization with taxpayer dollars sucks. Only a handful of people on the planet would disagree.
If it can't be clearly and simply explained (Plain Language) on one side of one piece of paper (8 1/2 by 11) then it's a financial instrument designed to kill you. These A-bombs will do their job. I hope your counter-party is TBTF so your grand-kids and great grand-kids can pick up the tab. These toys are great until the unwind.
+10
The deal is still with the collateral. Can't get away from it.Counterparty risk is the thing to cover, but you can't cover it in a LIBOR/OIS spread because you are dealing with the same counterparties who won't be able to pay you your profit. The big downside was that not only did the counterparty fail and lose bunches of money, the profit you thought you had from them was backed by collateral that proved worthless, and you lost money too. CONtagion (sic).
So the collateral can't be securities, it has to be real assets. SIMPLE! I gues this is a path that South American countries went down. Hmmm..may be real assets could be weapons held by mercenaries? or nukes? or a team of benefit receivers to clean your house? arghh.. what is real collateral?
This is why I love this site, man. Here's my take on counter-party risk and the hedge.
Example: You enter IRS with other banks. The few you trade with seem fine; but a lot of the other banks are going belly up, even big ones. You know that ultimately more banks will go under because the environment is poisonous. LIBOR goes up... nothing can stop it in a non-command economy.
The LIBOR-OIS is like a measure of the poisonous environment. It won't cover your specific counterparty risk, but it will cover a general index (work with me on that) of counterparty measured by the panel banks.
If the governments of the world are committed to subsidizing counterparty risk for an extended period of time, then you are waiting for totalitarianism or total system fail on an epic scale.
That market risk aspect is another way the trade expresses itself. It is just a way to play the eventual yield curve reversal and all that goes with it. I struggle right now with how aggressive I should be with exposure.
ok, back to thinking. I am still struggling with how you get the P/L on the LIBOR/OIS if the counterparty you did the deal with is gone and so is the exchange, But as you say, that is total meltdown. I think the collateral has to be real assets, maybe even houses or, heaven forbid, video stores. The objective is that the collateral has to provide cash flow and not be paper.
I am looking for the re-issue of yield curve bonds as SIV's by counterparties who might be around when the curve flattens to 4% then inverts at 6% at the short end and 5% at the long end..en route to 8% and 6% for a four year term. I still can't see signs of fair value or a rational Fed. The Fed is certainly no longer a moderator of the economy and is simply a bank that facilitates the other banks while the other banks pick up 2-4% on the yield curve on 10 trillion worth of liabilities. (Looks over at Japan and thinks hmmm..it will be two lost decades next year and a continuation of policies that have seen zombie banks poison the overall economy and create zombie corporates). Used to be "that aint working thats the way you do it, money for nothing and your chicks for free" now its that aint working thats not the way you do it, nothing for money and free for banks"
Here's my take, looking at the US boom-bust cycles of the last ten years or so, you notice something interesting...
historically equities always get smashed in every crash, but usual the higher end of the capital struture doesn't get banged as much. In 2008, there were hits higher on the capital structure, and even sovereign bonds got whacked. T-bills didn't even do so hot.
I think this is indicative of the policy failure of the Greenspan put. More and more of the capital structure gets synchronized to VIX.
The endgame will be failure on some level. Either govs firewall their exposure to the financial system, or we continue until T-bills get smashed. "It's the end of the world as we know it..."
Sadly this will be around the next will be the fifth crash I have been part of that has been "cured" by round tripping and expanding debt, starting in my teens in the early 70's. Debt saturation and tipping points are ever closer to that final precipice, call them ponzi, but we are locked into debt expansion in the public sector with no pay back. Its just a slop trough that politicians and central banks use to put their snouts in as a default option when their own incompetence and false promises simply fail because of the lack of care and responsibility taken. Their are many smart devices and metrics, but as a firm believer in short dated options as a first order instrument (not debt or equity) then I am afraid the Fed and the Government are selling vol/shorting delta to such a degree that the capitalist game simplycant be played. Of course, this concept is not in political thinking (neutral delta and neutral on volatility impact). Keynesian economics has failed and Austrian is simply too old fashioned. Obama is as big a trough feeder as anyone else. So disappointing.
This question may seem rather abstract and comples, but it is the same question asked by everyday people for millenia.
Is gold or fiat on one side the better money, or is wheat, tobacco, or oil?
Consumable money changes with civilization. Fiat has value strictly because of the political capital embedded in it. Gold has some properties different from other commodities, same in others.
Re: So the collateral can't be securities, it has to be real assets. and your above reply.
it seems to me that, since banks have ultimate and limitless backing of central (private) banks, they can pursue swaps as just another asset-seizure scheme. If the banks lose on their swaps, the taxpayers bail them out. And if the banks win on their swaps (with states, municipalities etc), the taxpayers bail out the states and municipalities and/or pay for the swap through loss of assets they're still paying for that were once owned by the government body. So, the taxpayers lose either way (which we already knew). So, the banks always win, and the taxpayers always lose. Is that not right?
well yes that is right in a rigged, "bail out failure and corruption" model. The banks are also playing amongst themselves (subject to ISDA rules) and pension funds too. These pension funds (State and Corporate) are attempting cover off long term inflation via CPI swaps and the amounts are very large. For the seller of the CPI swap to lay off the risk, there must be assets that grow with inflation. Once these stop (zero return from corporate america for the last ten years, i.e. zero return on assets = inflation, we are in the end game of the current business cycle. This cycle has been allowed to persist for ten years by intervention. The banks are just the jackals feeding on the carcass of the last business cycle and the Fed is the game keeper chasing them off from their feeding frenzy by creating smaller carcasses close by. Still, the next business cycle (Greenspan thought it was intellectual, but the IQ that the west has over emerging markets has disappeared, Bush thought it was taking over Iraq's oil, but well let's face it, an annual pentagon budget of 750 billion is equivalent to 10 billion barrels a year at 75 bbl compared to net demand of just 750 million demanded so that didnt work out either).
But your general premise is correct and the system is hopefully conflicted with the play do of swaps and securities markets in general. Damn I wish there were solutions that would just leave the federal and monetary authorities completely sidelines. A new currency to represent the payment of value would be a good start. God knows a new $100 bill isn't valuable any more. And this years deficit needs 14 billion of them!!
DOW chart threatening to break out.
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There will eventually be a market that is too big for the Fed to control. The Fed is coiling up all the markets, and when one of the huge ones busts out, they finally won't be able to control the bursting - the mean reversion will have to take place. Either the Fed will have to move up rates themselves, or eventually the markets will absolutely force the issue, disempoweing the Fed with them fully losing control.
Is this soapbox steady?.... harumph....
Ideology is the devil and ego is the enabler.
When folks don't let facts get in the way of a good argument, they are not making an argument they are proselytizing.
If the right can rally around a flip-flopper from Massachusetts (Romney) given that they questioned the patriotism of a war hero (Kerry) and applied the same appellation, then they can also fall for the next American demagogue, the Manchurian Mountain Mama.
If the elected left (Barry Dunham) can effectuate an insurance friendly health 'reform' and support an ubiquitous bankster friendly bailout than they deserve to be painted with the same corporatocracy brush that they purportedly have spent their careers 'fighting'.
If folks that trumpeted the merits of a free market can just as thunderously trumpet the merits of its' demise (Nancy Capitalists) than they most certainly will insure that the blessings of liberty and her entrepreneurial spoils will neither be afforded to them nor their forebears.
The strength of our democracy is the rule of law and the equality of all men and women under it. The strength of our financial system is prudent regulation and a free market that rewards winners and pins losers. The strength of our state is to promote domestic tranquility and the general welfare by assisting the disadvantaged so that they may have the opportunity to secure blessings for themselves and their posterity.
Greedy before guilty does not protect the innocent and it does not promote the chaste.
Those that fail to stand for something will fall for anything.
Yes! So how come we can diagnose the disease but we can't find a cure? Maybe its time to use cancer research methodology to analyse the problem. I am not willing to be proselytized into converting into judaism or islam, thought I suppose I am a gentile, or be converted to communism by default or revolution. I would like to think that "I come toward" a future path that is being dicovered via media such as this.
I suggest a solution that involves cauterising the cancer by sectioning off the debt of around US$3 trillion that is irrecoverable and fund it by reducing all spending by 38%, across the board in whatever goes for "
Costs for Mandatory Programs That CBO's March 2010 Baseline Assumes"
including the 700 billion dollars per annum on defense.
Certainly spending 4 trillion dollars and only getting in 2.5 is not something I would entertain, that is, spending 60% more than I earn when I have control over my finances. Debt is the evil here and it is the cancer.
ok found the trillion dollar mans (woops) presidents budget and the CBO's baseline changes.
http://www.cbo.gov/ftpdocs/112xx/doc11231/index.cfm
released in March, just the odd ten trillion deficit difference between the CBO baseline and the prez's budget over the next ten years on top of the 3 trillion for the last two years. If all goes to plan at the moment, I mean taking in 35 trillion (tax of 120,000 bucks for every man woman and child over the next ten years) and planning to spend 45 trillion (or 150,000) seems pretty stupid to me. But then what do I know.
oh and just in case you thought the CBO might be good at their job, check out the rather neat and convenient drop in unemployment benefit paid on the excel spreadsheet between 2010 ($145 billion) and 2011 ($88 billion). Can you see a fall in unemployment benefit from 10% to 6% next year? Well its only 57 billion who cares right? I guess it only matters if you are getting benefit. Drops to just $48 billion by 2014. Unemplyment rate of what? 3.5%?
Dontt worry though, Fraudie and Funny (woops Freddie and Fannie) funding will drop from $110 billion in 2009 and 2010 to just 10 billion for 2016 and 2017. AND social security wont hit 1 trillion until 2017 (from 700 billion in 2010, so just a 45% increase when unemployment is falling that much. You couldn't pay a bank to dream up numbers like this.