Positions in the OTC derivatives market went up in the
three years since the last Triennial survey (+15%, or 5%
annualized) to $583 trillion, but at a slower pace than
during the previous period from 2004 to 2007 (+ 131%, or 32%
per year). Data from the semiannual survey shows that the
modest overall increase is the result of a surge in
positions until June 2008, followed by a decline in the wake
of the financial crisis. Growth in gross market values,
which provide a measure of the counterparty risk of these
positions at prevailing market prices, increased far more
than notional amounts outstanding, going up by 122% to
$25 trillion at the end of June 2010 . This compares to a
growth of 74% during the previous (2004-07) reporting
The modest overall growth in notional amounts
outstanding hides significant variations across risk
categories. The highest growth was recorded in the interest
rate segment of the OTC derivatives (25%), bringing the
share of this risk category in the market total to 82%.
Positions in foreign exchange derivatives went up by 9%. By
contrast, amounts outstanding of the other OTC segments
declined substantially, ranging from 30% and 40% (equity and
credit) to 60% (commodity contracts). Sharp movements in
asset prices, related to a reassessment of risks during the
financial crisis, drove up gross market values of foreign
exchange (100%), credit (88%) and interest rate derivatives
(175%). Gross market values of equity and commodity
Data from the semiannual survey shows that, in the first
half of 2010, growth in amounts outstanding was subdued or
negative in all risk categories. Positions of all types
of OTC derivatives fell by 4% to $583 trillion, following
the 2% increase in the second half of 2009. The decline
occurred against the backdrop of deteriorating market
sentiment related to the European sovereign debt crisis.
However, much of the contraction reflected a valuation
effect due to the depreciation of European currencies
against the US dollar, the currency in which the data are
reported. In contrast to the decline in the positions, gross
market values for existing OTC contracts rose by 15% to $25
trillion at end-June on the back of sharp asset price
movements. Gross credit exposures, after netting agreements,
which had dropped slightly in the half-year up to end-2009
(-6%) increased by 2% to $3.6 trillion.
Notional amounts outstanding of credit default swaps
(CDS) declined for the fifth consecutive semiannual period,
largely due to terminations of existing contracts. Gross
market values for single-name contracts dropped by 16%,
while those for multi-name contracts rose by 10%. The latest
semiannual survey introduces additional information on the
importance of central counterparties (CCPs) in the CDS
market. At end-June 2010, about 11% of CDS positions were
vis-à-vis a CCP 1 . The CDS counterparty
breakdown for contracts with other financial institutions
has also been expanded. In particular, special purpose
vehicles (SPVs) and hedge funds are singled out for the
first time. CDS contracts with hedge funds and SPVs account
for about 5% and 4% respectively of total notional amounts
outstanding with other financial institutions.
A detailed analysis of elements of the 2010 Triennial Survey
and of the end June 2010 semiannual OTC derivatives statistics
will be made available in the forthcoming December BIS Quarterly
Review. In particular, the publication will include special
features on structural changes in the CDS market, on derivatives
in the emerging economies, on the drivers of growth in FX
markets, and a user's guide to the Triennial survey.
“Every single provision in the bill is dependent on regulators
doing well, which is exactly what regulators did very badly in
the run-up to the crisis, there really is a question as to
whether we can do anything differently this time.”
The fight in Congress over how to increase transparency and reduce risk in the
swaps market nearly derailed the Dodd-Frank regulatory bill and it took a
contentious all-night session to reach agreement on the outlines. Lawmakers left
many specifics to the CFTC and the Securities and Exchange Commission, with the
first drafts of some rules to be published by the end of 2010. Since President
Barack Obama signed the law July 21, calling its passage a triumph over “the
furious lobbying of an array of powerful special interest groups,” those same
groups have turned to regulators to try to blunt the impact on profits.
“The volume and intensity of the lobbying is unprecedented in
my experience at the agency,” Chilton said. “They all have an
ask. The types of loopholes that people are suggesting exist are
either non-existent or very farfetched.”
The law gives the CFTC jurisdiction over commodity, interest
rate and some credit default swaps, the largest share of the
derivatives markets. The financial stakes are high. U.S.
commercial banks held derivatives with a notional value of
$223.4 trillion in the second quarter, according to the
Office of the Comptroller of the Currency. Those banks
reported trading revenue of $6.6 billion in the quarter, a gain
of 28 percent from the same period a year earlier.
After the Dodd-Frank bill passed, CFTC Chairman
Gary Gensler announced that the commission would
post the names of anyone who came to discuss the rules.
According to the agency’s website, there were more than 230
meetings from July 26 through Oct. 8. Among the firms were
Cargill Inc., Vitol Group,
JPMorgan Chase & Co.,
Morgan Stanley, and Bloomberg LP, parent company of
Bloomberg News, which has a swaps trading platform, according to
testimony and documents the companies have provided to the CFTC.
In September alone, participants included 14 people from
Morgan Stanley, 18 from Goldman Sachs and about a dozen from the
Air Transport Association, the airline trade group.
The lobbying began before the legislation was passed as firms
anticipated new rules. As of early August, the commission had
met with 126 different companies this year, according to
lobbying records examined by the Washington-based
Center for Responsive Politics. That was the highest since
the center began tracking the records in 1998, 20 percent higher
than in all of 2009 and 68 percent higher than in 2008.
Consumer advocates said they hoped the regulators would
fulfill the intent of lawmakers and not weaken oversight. “It
would send a message that the rulemaking process isn’t for sale
to the highest bidder,” said
Barbara Roper, director of investor protection at the
Consumer Federation of America, who has met with the CFTC to
discuss business conduct standards.
Scott O’Malia, 42, a Republican who was appointed last year,
said the agency invited the input. “People have an interest in
how the market turns out. They are businesses, and we get that,”
he said. Still, he said, “If anyone is coming in trying to
change the statute through rulemaking, they are fooling
Gensler has asked Congress to increase the agency’s
budget by 69 percent next year to $286 million and predicts
the agency’s budgeted staff of about 650 will need to grow to
more than 1,000 to meet its new demands.
Roper of the Consumer Federation, who celebrated the
enactment of the law, said she sees danger in the endgame.
“Every single provision in the bill is dependent on
regulators doing well, which is exactly what regulators did very
badly in the run-up to the crisis,” she said. “There really is a
question as to whether we can do anything differently this
The proposals by the Commodity Futures Trading Commission
would be the first major step by the agency toward regulating
the opaque $615 trillion over-the-counter derivatives market.
The measures are part of broad new powers bestowed to the
CFTC in the Dodd-Frank Act, named for its authors Sen. Chris
Dodd (D., Conn.) and Rep. Barney Frank (D., Mass.). That law
aims to reduce risk in the markets by requiring swap dealers and
major traders to execute routine swap contracts on trading
platforms and use clearinghouses, which guarantee trades. Swaps
are contracts often used by firms to hedge risks such as
interest-rate changes, but they can also be used by speculators
to profit from price movements.
If a majority of commissioners vote on the proposals Friday,
they will be issued for public comment. A second vote is then
needed before they can be implemented. The rules on governance
are likely to be the most contentious because they contain
proposals to restrict certain entities, like banks, from
controlling a large voting stake in clearing and trading venues.
The plan would prohibit members of trading platforms and
exchanges from individually owning more than 20% of the voting
The overwhelming majority of derivatives since 1991 are special performance
contracts devoid of any standards. As such there is no market whatsoever for
them. As conditions change the only way to keep from bankruptcy is to add more
OTC derivatives to your chain to offset the new conditio That means the OTC derivatives are by nature permanent agreements that can only
grow. That means we are in greater financial danger than we were in 2008. That means QE to infinity or the end of Democracy.
IBM could have to hold off on acquisitions and see its organic growth
stunted if it is included on a list of major derivatives users, the technology
group’s director of global funding said. Large companies in the US are lobbying hard to escape being designated “major
swap participants” by regulators implementing the
Dodd-Frank financial reform act. Such a designation will require companies
to post margin against derivatives trades. Tammy Evans, director of global funding at IBM, said if the company were
designated an MSP “you could potentially have $5bn of capital that’s held up
with margin requirements” on its $40bn-$45bn derivatives portfolio.
The rules being proposed by the Commission will need approval
both from EU member states and the European parliament. The aim
is to have them in force by mid to late 2012.
The proposals follow agreement by G20 leaders last year to
standardise derivatives trading and move them on to exchanges or
electronic trading platforms where appropriate. The proposals
will closely align the EU with the new regime that is coming
into force in the US.
The rules will require standard OTC derivatives to be
processed through clearing houses – a move aimed at reducing
systemic risk arising from a default of one party in an OTC
deal. They will also require OTC contracts – the bilateral
agreements between buyers and sellers – to be reported to “trade
repositories” or data banks, and for this information to be
available to regulators.
But Brussels also plans to make it more expensive for firms
to deal in non-cleared contracts, by requiring them to hold more
capital against these – although that measure will be introduced
in separate legislation shortly.
The short-selling proposals suggest that investors must
disclose significant net short positions to regulators once
these amount to 0.2 per cent of the issued share capital of a
company, and to the market at a higher 0.5 per cent threshold.
So-called “naked” short selling – where traders sell a
security without owning it or borrowing it in expectation of
buying it back at a cheaper level – will only be allowed in
There will be a specific regime for telling regulators about
significant net short positions in credit default swap positions
related to EU sovereign debt issuers. The proposals also include
powers to allow national regulators to restrict short selling in
sovereign CDSs during periods of volatile trading
Banks, companies and trade associations challenged federal
regulators Friday over the controversial question of how to
regulate derivatives under the new Dodd-Frank financial revamp,
the first big day of posturing since the law was enacted last
The meetings, particularly a three-hour roundtable hosted
jointly by the Commodity Futures Trading Commission and the
Securities and Exchange Commission, illustrate how Wall Street's
attention has shifted from Congress to the federal agencies that
have to interpret the law by writing hundreds of new rules.
Perhaps nowhere is the attention to detail more apparent than
the focus on complex financial instruments known as derivatives,
in part because the rules will impact scores of companies and
can affect how hundreds of billions of dollars in credit moves
through the economy.Jason Kastner, vice chairman of the Swaps
and Derivatives Markets Association, said if regulators don't
allow more companies to participate as part of derivatives
clearinghouses, the concentration of big banks dominating these
firms would lead to a "real risk that we're going to end up
right where we started."
In brief - there has been $25.85 billion in YTD structured
note issuance, and over $60 billion in global interest-linked note
volumes. An amusing excerpt from the brief: "Sales of notes linked
to wheat jumped this month after Russia’s worst drought in 50
years spurred a surge in the price of futures contracts on the
grain. Banks including DZ Bank AG and Royal Bank of Scotland Group
Plc, issued 82 wheat-linked warrants this month, compared with a
total of 159 in the first seven months of the year, according to
data compiled by Scoach, the structured products trading platform
run by Deutsche Boerse AG and Switzerland’s SWX Group. The listed
notes, called knock-out warrants, offer investors a leveraged way
to bet on the price of wheat." For all those who thought Wall
Street was dormant in the post-CDO implosion vacuum, this is a
rough wake up call - it appears no matter what, idiots and their
money are promptly parted, and the world's foremost financial
innovators will always find a way (and a product) to guarantee
that. And it is very refreshing to see that Germany's DZ Bank has
almost learned from the CDO bubble: the questionably solvent
German bank dominates the Structured Note market with $7.2 billion
in issuance to date, followed closely by such stalwarts of
financial stability as Barclays and Deutsche Bank.
A historic relationship between US government bonds and interest rate swaps has broken down this week, for only the second time, as a flood of corporate debt issuance from banks pushed 10-year swap rates below Treasury yields. The negative spread between swaps and “risk free” Treasuries
occurred for the first time in March and that inversion only
abated at the end of April
Hospitals that made wrong-way "swaps" and auction-rate bets
are blaming Wall Street. The Street says the hospitals had reaped
millions of dollars in savings before the market turned sour.
Some hospitals are paying millions of dollars in penalties to
get out of derivatives contracts, after betting incorrectly that
interest rates would rise. Other hospitals are paying higher
interest rates. At many, these ill-fated financial bets have
contributed to layoffs and scuttled projects.
More than 500 nonprofit hospitals—at least one in six—bought
interest-rate "swaps" in a bid to lower their borrowing costs,
estimates Municipal Market Advisors, a Concord, Mass., consulting
firm. The swaps allowed hospitals to act much like homeowners
switching from a floating-rate mortgage to fixed-rate one, betting
on rising interest rates.
For a fee, the hospitals received a fixed rate to sell bonds,
lower than the municipal-bond market at the time. These bets
backfired when the Federal Reserve cut interest rates to nearly
zero from more than 5% in 2007.
Hospitals also issued auction-rate securities—which reset bond
prices weekly or monthly through auctions—that represented about a
third of the $330 billion market for these derivatives. Hospitals
paid Wall Street firms more than $120 million in fees for the
securities between 2005 and 2007, said data firm Thomson Reuters.
That market dried in the 2008 financial panic, leaving hospitals
with higher interest rates.
Wall Street firms and many hospital executives say
interest-rate swaps were a plain-vanilla product that they have
sold for years and say no one could have foreseen the crisis that
cratered the auction-rate securities market. "For years and years
it was a smart strategy," said Richard Clarke, president of
Healthcare Financial Management Association, a trade group.
"Hospitals made money on these for a long time."
The hospital deals were part of a larger stampede into
swaps contracts by cities, schools and other taxing districts
seeking to lower their payments on bonds they sold. Some strapped
hospitals only now are beginning to break the contracts and pay a
financial penalty for it.
Swaps were "the Edsel of the time," said John Hackbarth Jr.,
chief financial officer of Owensboro Medical Health System of
Kentucky, which recently paid about $14 million to end an
interest-rate swap with Merrill Lynch, now part of
Bank of America Corp.
Attached are several charts used to explain to confused
politicians all they need to know about the biggest ponzi
scheme market ever created (synthetic derivatives), how these
derivatives are created, how the leverage attributed to just
one asset can result in infinite amplification of risk, and
how Goldman is in the very middle of a web which encompasses
tens if not hundreds of trillions in derivative counterparty
exposure with virtually every single other financial company
in the world.
Amplification: this explains how you take
a small pool of assets (in this case mortgages) and increase
the bettable risk almost to infinity courtesy of synthetic
products like CDOs which are nothing but side bets with an
unlimited cap on the total risk exposure. The original
mortgage is cut up into tranches, which are subsequentlly
split up into CDOs, whereby risk can be held, sold off, or
side-betted via CDS (which is what AIG would be doing by
selling CDS on milions of assorted CDO tranches). In the
example below the Glacier Funding CDO 2006-4A C has an
original value of $15 million which trough CDO-intermediated
amplification, or process in which bits and pieces of it are
repakcaged in various synthetic afterproducts, ends up being
$85 million. In theory there is no limit to what the total
amplified value could be, as synthetic products by definition
are created out of thin air, and just need a willing buyer and
Deal Creation: For those who have not
spent hours poring over the Abacus org chart, this is a
summary of how a traditional CDO was structured and
subsequently insured (incidentally, this is not the infamous
"John Paulson" Abacus deal for which Goldman is currently
being sued). Of particular note here is the box in the lower
left, the CDS issuers, AIG, TCW and GSC, who were the dumb
money, or those infamously collecting pennies before the
housing crash steamroller. As the chart shows, they were
collecting $3 million a year in CDS payments, and stood on the
hook for $1.8 billion in case the CDO collapsed, or
specifically if the underlying reference assets stopped
generating enough cash through specific attachment levels.
Leverage: here are the key counterparties
on the hook for just the above deal, Abacus 2004-1. No
surprise, the biggest counterparty, with total downside loss
is AIG, at $1.76 billion. The running annual CDS premium
payment? $2.1 million. As the exhibit notes, in the end
"Goldman negotiated $800 million from AIG." Other losers
included TCW and GSC, and Abacus itself via secondary market
Counterparties: The money chart, this
shows who Goldman's key derivative counterparties were as of
June 2008. While oddly enough AIG is not on this chart
(potentially as this is pro forma for the bailout), it shows
just what a great web of interconnected synthetic exposure
derivatives create. As of this snapshot, Goldman had $20
trillion in notional counterparty exposure. This number has
since ballooned. It also shows that the collapse of any
individual actor in this maze would very likely result in the
collapse of the entire financial system. While we do not know
whether the notional depicted is gross or net, we are
comfortable that the $2 trillion in Interest Rate Product
counterparty exposure between Goldman and JPM and RBS (for
example) would be sufficient to blow up either of these
parties should the interest rate complex move violently in a
direction and amplitude presumed impossible by either firm's
VaR models. We are amused to note that Blue Mountain, a hedge
fund, has $590 billion in counterparty exposure to Goldman yet
no discount window access. Same goes for Citadel in Equity
Products, which incidentally we learn is Goldman's largest
counterparty in this category. In the very much maligned
Commodity Product category, Goldman's key counterparties are
Morgan Stanley with $96 billion, Barclays with $69 billion and
Tempo Master with $55 billion, etc. So next time you wonder
who aside from JPMorgan is writing all those synthetic gold
shorts out of thin air, now you will know. Yet the most
notable take home from this chart is that courtesy of its
extensive network, Goldman knows full well just how every
single bank and hedge fund is positioned, and can easily make
prop trading decision based simply on counterparty exposure
(Goldman tracks every single trade inception, transfer and
novation with all its counterparties to know up to the minute
who owns what). Welcome to completely legal frontrunning.
U.S. Commodity Futures Trading Commission Chairman Gary Gensler
appears to be on verge of achieving a big victory in his battle to
impose stricter position limits on major energy futures contracts.
Back in January, Gensler unveiled proposals for tough new
limits on futures positions in U.S. crude, natural gas, gasoline,
and heating oil. Unlike previous limits set by exchanges, these
would be set by the commission itself and would aggregate all
positions in economically equivalent futures and options for a
particular commodity. The proposals were designed to limit
exemptions for firms seeking to hedge financial rather than
physical exposures and largely restrict financial and physical
hedgers from also running speculative positions.
U.S. lawmakers worked through the night to finalize on
Friday new legislation for the $615 trillion
over-the-counter derivatives market.
Here are some of the key agreements for swaps rules
agreed to by a conference panel of Senate and House of
* Banks can trade foreign exchange and interest rate
swaps in house, as well as gold and silver swaps, and
derivatives deigned to hedge their own risk.
* Banks need to spin off desks to affiliates to handle
agricultural, energy and metals swaps, equity swaps, and
uncleared credit default swaps.
* Non-financial companies "using swaps to hedge or
mitigate commercial risk" are exempt from clearing the
trades, as long as they explain to regulators how they are
meeting financial obligations.
* The financing arms of manufacturers like Ford Motor
Deere & Co (DE.N),
Caterpillar Inc (CAT.N)
and Boeing (BA.N)
and other "end users" do not have to clear swaps when they
assist in selling the parent company's products.
* Clearinghouses will not be forced to accept credit
risk from other clearinghouses -- interpreted as a win for
the CME Group (CME.O),
the world's biggest operator of futures exchanges.
* Federal Reserve governors and the Treasury secretary
would need to agree before a clearinghouse could access
the Fed's emergency funds.
* Firms engaged in a "de minimis" amount of swap
dealing with or on behalf of customers will be exempt from
new rules for swaps dealers.
* Capital and margin requirements for uncleared swaps
done by non-bank swap dealers and major players will be
set at "appropriate" levels, softening earlier language
that said levels would be as strict or stricter than those
set for banks.
* Traders can use non-cash collateral to meet margin
* Regulators "shall" set limits on speculative
positions "as appropriate" but have authority to exempt
traders or types of swaps from the limits.
* Movie futures will be banned.
* There will be no ownership restrictions set for major
swaps players, banks and financial companies involved in
clearinghouses, exchanges, or swap execution facilities.
* Regulators will have at least a year after the time
of passage to implement the legislation.
Senator Blanche Lincoln will accept a House compromise on a
derivatives measure that would force banks to push swaps trading
into subsidiaries, clearing the last major hurdle in the financial
A Bankrupt BP - Worse For The Financial World
Than Lehman Brothers?
The BP crisis in
the Gulf of Mexico has rightfully been analysed (mostly)
from the ecological perspective. People’s lives and
livelihoods are in grave danger. But that focus has
equally masked something very serious from a financial
perspective, in my opinion, that could lead to an
acceleration of the crisis brought about by the Lehman
People are seriously underestimating
how much liquidity in the global financial world is
dependent on a solvent BP. BP extends credit – through
trading and finance. They extend the amounts, quality and
duration of credit a bank could only dream of. The Gold
community should think about the financial muscle behind a
company with 100+ years of proven oil and gas reserves.
Think about that in comparison with what a bank, with few
tangible assets, (truly, not allegedly) possesses (no
wonder they all started trading for a living!). Then think
about what happens if BP goes under. This is no bank. With
proven reserves and wells in the ground, equity in fields
all over the planet, in terms of credit quality and credit
provision – nothing can match an oil major. God only knows
how many assets around the planet are dependent on credit
and finance extended from BP. It is likely to dwarf any
banking entity in multiples.
And at the heart of
it all are those dreadful OTC derivatives again! Banks try
and lean on major oil companies because they have exactly
the kind of credit-worthiness that they themselves lack.
In fact, major oil companies, conversely, spend large
amounts of time both denying Banks credit and trying to
get Bank risk off of their books in their trading
operations. Oil companies have always mistrusted bank
creditworthiness and have largely considered the banking
industry a bad financial joke. Banks plead with oil
companies to let them trade beyond one year in duration.
Banks even used to do losing trades with oil companies
simply to get them on their trading register… a foot in
the door so that they could subsequently beg for an
extension in credit size and duration.
banks, all trading was based on what the early derivatives
giant, Bankers Trust, named their trading system: RAROC –
or, Risk Adjusted Return on Credit. Trading is a function
of credit bequeathed, mixed with the risk of the (trading)
position. As trading and credit are intertwined, we might
do well to remember what might happen to global liquidity
and markets if BP suffers what many believe to be its
deserved fate of bankruptcy. The Intercontinental Exchange
(ICE) has already been and will be further undermined by
BP’s distress. They are one of the only "hard asset"
entities backing up this so-called exchange.
BP does go bust (regardless of whether it is deserved),
and even if it is just badly wounded and the US entity is
allowed to fail, the long-term OTC derivatives in the oil,
refined products and natural gas markets that get
nullified could be catastrophic. These will kick-back into
the banking system. BP is the primary player on the
long-end of the energy curve. How exposed are Goldman sub
J. Aron, Morgan Stanley and JPM? Probably hugely. Now
credit has been cut to BP. Counter-parties will not accept
their name beyond one year in duration. This is unheard
of. A giant is on the ropes. If he falls, the very earth
may shake as he hits the ground.
As we are
beginning to see, the Western pension structure, financial
trading and global credit are all inter-twined. BP is
central to this, as a massive supplier of what many
believe(d) to be AAA credit. So while we see banks roll
over and die, and sovereign entities begin to falter… we
now have a major oil company on the verge of going under.
Another leg of the global economic "chair" is being
viciously kicked out from under us. Ecological damage is
not just an eco-event on its isolated own. It has been
added to the list of man-made disasters jeopardizing the
world economy. The price tag and resultant knock-on
effects of a BP failure could easily be equal to that of a
Lehman, if not more. It is surely, at the very least,
All the counter-party risk associated
with the current BP situation means the term curve of the
global oil trade has likely shut down. Here we have yet
another credit-based event causing a lock-up in markets
that will now impede trade and commerce. It looks like an
exact replication of the 2008 credit market seizure could
ensue all over again – and it could probably be a lot
worse. The world is in a far more delicate state now.
Although never really discussed, the world is highly
reliant on BPs provision of long-term credit to many core
industries. Who makes good on all the outstanding paper
that so many smaller oil, gas and electricity companies,
airlines, shipping companies, local bus, railway and
transportation networks that rely on BPs creditworthiness
and performance for? It doesn’t take a genius to figure
out how this could all unwind. If BP has to be bailed-out,
like a bank, the system will have to print even more
unimaginable amounts of money.
intellectually lazy and slow to realization, as it often
is, probably has not woken up to it yet – but the BP
crisis could unleash damage similar to the banking crisis.
A BP failure through bankruptcy could make Lehman look
small in comparison, and shake the financial house of
cards we live in even more severely. If the implicit
danger of the possibilities imbedded in such an event
doesn’t make an individual now turn towards gold at full
speed, it is likely that nothing will.
By Jim Sinclair at JSMineset via Oilprice.com who
offer detailed analysis on Oil, alternative Energy,
Commodities, Finance and
Geopolitics. They also provide free Geopolitical
intelligence to help investors gain a greater
understanding of world events and the impact they have on
certain regions and sectors. Visit:
On May 6th, Greece’s 2-year CDS rate surged to a record
1,195-basis points, and triggered the historic “flash crash” on Wall
Street, - an intra-day, 1,000-point meltdown in the Dow Jones
Industrials, climaxed by a shocking 700-point drop, in less than
20-minutes, to below the psychological 10,000-level. Since the
mainstream media was unfamiliar with the movements of the Greek CDS
market, it peddled a story, that a computer glitch caused the “flash
Rep. Barney Frank signaled that a controversial derivatives provision
in the Senate's financial-regulation bill could be stripped out during
negotiations when the two chambers hammer out compromise legislation.
Dylan Ratigan and Berney Sanders do a great summary of the
various parallel amendment attempts to put some teeth into Dodd's
joke of a bill. Ironically, as misguided as it is in most regards,
at least Merkel's "reform" showed the kind of conviction that Dodd
and his mostly incompetent colleagues will never be able to
muster, as they scramble all over each other to collect the scraps
that Wall Street has promised them so long as Goldman can generate
annual revenues of $60 billion and above. And since our
politicians would make the Amsterdam Red Light district blush, you
can bet the end results of the Senatorial corruption will be
unprecedented, resulting in a bill that achieves the opposite of
what it is intended to do: i.e., make banks even stronger and
gives the Fed even more power. Which is why any debates about the
merits of Merkley-Levin or blah-blah are pointless. The only final
arbiter in the reg reform issue will be the market itself, which
will resolve everything the second it crashes once and for all.
And judging by the size of the carry unwind currently occurring,
we may not have to wait long. Which is why we think that Angela
Merkel may have brought about the unwinding of the market that
will be the one real catalyst to any real reform: after all, for
people to express any interest in what is going on in Wall
Street's Washington branch, people will have to lose everything...
again. As Senator Sanders says, the American people have got to
stand up. He is right, however the only thing that will wake
America out of its slumber will be one more terminal crash, the
one that corrupt and busted finreg reform was supposed to prevent.
"Firms such as Citigroup and Merrill Lynch [and others] were able to
create complex securities backed by recklessly underwritten [often
fraudulent] mortgages, knowing that they could pass the risk along to
someone else who had less information about the underlying loans. [The]
$62 trillion credit derivatives market allowed Wall Street to lend
without having confidence in the men and women it lent to. Wall Street
hedged away the risk of lending and in the process undermined the entire
3- Apulia, an Italian
regional government on the Adriatic
University in Cambridge, Massachusetts,
year to pay more than $900 million to terminate swaps that assumed
interest rates would rise.
interest-rate swap deals popular with European municipalities, a bank
would agree to cover a locality’s fixed debt payment and the government
or agency would pay a variable rate gambling its costs would be lower --
and taking on the risk that they could be many times higher.
Use of swaps in
Europe soared in the late 1990s and early 2000s because banks pitched
them as the easiest way to reduce costs on fixed-rate loans, according
to Patrice Chatard, general manager of Finance Active, which helps more
than 1,000 localities across
Western Europe manage their debt.
regional governments in Europe mainly get their financing from banks,
while in the U.S. they primarily raise funds by selling bonds to
investors. Municipalities and other local authorities in the European
Union’s 27 member states had a combined debt of 1.21 trillion euros in
2008, according to Eurostat, the EU’s statistics agency.
officials used up-front cash payments from guaranteed rates at the
beginning of swap contracts to artificially lower their short-term
financing costs and live beyond their means, said Emmanuel Fruchard, who
is a city council member in Saint-Germain-en-Laye, near Paris.
“These municipal swaps are the same thing as Greece,” said Fruchard, a
former banker at Credit Lyonnais, now a unit of Credit Agricole SA, who
designed swaps in the early 1990s. “It’s all trying to dress up your
Poland and Belgium also used derivatives to manage fiscal deficits,
Walter Radermacher, the head of Eurostat told EU lawmakers in Brussels
yesterday without being specific.
Municipalities are having to rewrite their budgets. Saint- Etienne
raised taxes twice, slashed by three-fourths a plan to renovate a museum
commemorating the region’s extinct coal mining industry and sparked the
cancellation of a tram line. Pforzheim, on the edge of the Black Forest
in Germany, is scrimping on roads, schools and building renovations.
Known as Gold City for its historic jewelry and watch- making industry,
Pforzheim was ordered by the Baden-Wuerttemberg regional government
office in Karlsruhe to cut its budget by 240 million euros, or about 12
percent annually, over the next four years because of a 55 million-euro
loss on derivatives and a projected 50 million-euro annual shortfall
from a decline in tax revenue and rising social costs.
The town followed the advice of Deutsche Bank in taking out bets on
interest rates in 2004 and 2005, according to Susanne Weishaar,
Pforzheim’s budget director until March.
More than 1,000
municipalities in France had 11 billion euros in “risky” contracts at
the end of 2009, according to Paris-based Finance Active. In Italy,
about 467 public borrowers faced losses of 2.5 billion euros on
derivatives as of the end of September, according to the Bank of Italy.
In Germany, Deutsche Bank sold contracts based on the difference between
long- and short-term rates to about 50 municipal governments and
utilities. Local authorities also bought swaps from regional banks and
Commerzbank AG. No national consolidated figures exist, according to
Roland Simon of Simon & Partner, a law firm in Duesseldorf.
For cities like Saint-Etienne, the risks from buying swaps were out of
proportion to the potential savings.
confused chatter in the bond community as to why the negative swap
spread story (anywhere between 7Y and 30Y) is being largely ignored by
the media. After all, the associated market,
which according to the BIS was roughly $154 TRillion
in June 30 makes the Greek bond debacle and various sovereign CDS
discussions in the media pale in comparison. As several bond traders
pointed out, the likelihood of negative spreads
having been modelled out by the TBTFs is very low, if any, meaning that
unhedged bank IR-swap exposure is suffering massively, and
is likely to surpass all record past prop desk losses. In
fact, rumors abound that a few of the desks having placed leveraged bets
on spread divergence over the past months and years are currently in
critical condition, yet nobody is discussing this for fear of another
round of bank run concerns among the TBTF banks. What is odd, is that
the Primary Credit borrowings
are now at almost financial crisis lows of just
under $9 billion,
leading many to speculate that banks now satisfy all of their short-term
funding needs via the fungibility of excess reserves (and indicating
once again that the Fed's discount rate hike was the most irrelevant
action in a history of irrelevant actions). And just in case there is
still confusion as to what negative swap spreads mean, here is a useful
big news is that 10y swap spreads (Swap Spread = Libor Rate - UST
Yield; e.g. 10yr swap spread = 10yr Libor Rate - UST 10yr yield. This
spread has always been positive, today it is negative implying that
UST 10y yields have risen above 10y Libor rates) have fallen below
zero (Exhibit 1). But the bigger questions are how do we define value
in spreads and how much more inverted can 10y spreads go? At the
height of the crisis in 4Q08, 30y swap spreads got to -41bps and have
remained inverted ever since. The inversion of 30y spreads had more to
do with technical, exotic and hedge-related factors. But those
elements are missing from the inversion of 10y spreads. That's what
makes it interesting. Today we view the inversion in 10y swap spreads
as a harbinger of the massive supply of UST debt that will ultimately
drive yields higher.
What drives swap
in the late 1980's and early 1990's, swaps were a ground-breaking
innovation. It was a “magic formula” to turn long-term liabilities
into short-term liabilities. ABC Company would issue (that is, pay an
interest rate) on, say, 10yr debt in the market, then receive a 10yr
fixed interest rate in the Libor market while simultaneously paying a
3-month floating Libor rate (Exhibit 2). And voila, ABC Company
'swapped' a long-term fixed liability for a cheaper and easier to
manage short-term liability. Magic! But things were simpler in days of
yore. Swaps were a less volatile vehicle used by corporations to
manage cash flows on their debt. They used swaps because they could
customize the end dates of their fixed cash flows, rather than relying
on US Treasuries with their pesky issuance cycles and inherent
technicalities. For example, 10y spreads from 1992–1997 trade in a
range from 28bps to 41bps, pretty narrow. But this simplicity allowed
us to understand what drove swap spreads. These factors were
between Libor and repo rates
The slope of
the yield curve
deficit and UST supply
first point argued that Libor rates should be higher than UST rates
because there was a 'repo-specialness' premium between UST’s and
Libor. The second point refers to corporate issuance: if the curve
steepens, then corporations are more likely to swap their long-term
liabilities at higher rate levels into short-term liabilities at lower
rate levels. The last point refers to the relative level of UST
issuance. If the US economy slows and goes into a deficit, then the US
will issue more Treasuries to fund itself, therefore narrowing swap
spreads (Exhibit 3). Currently, we have a high 9.9% deficit to GDP
ratio and correspondingly, a $2.4Tr gross issuance of UST’s in 2010.
What has changed?
Later in the
1990s and over the last decade, the swaps market took on increased
importance not just as a hedging vehicle but also as a speculative
vehicle. What drove swaps over the past 10 years has been hedging the
interest rate sensitivity in mortgages. But today, a case can be made
that mortgages are less interest rate sensitive than in the past
(i.e., less negatively convex). The reason is that households may be
less able to refinance their mortgages for a given change in interest
rates, because refinancing is more related to FICO scores, credit
availability, loan-to-value, incomes, etc. We believe swap spreads
will narrow and remain inverted as interest rates have stayed low and
stable, volatility has fallen, spread products have been narrowing,
and there is little hedge-related need to pay fixed in swap. Add to
that the old-time reasons, which are becoming more popular drivers of
swap spreads today, of reduced specialness premiums, tighter
repo-Libor spreads, steeper yield curves and monstrous US Treasury
supply. All of which become the contributors to 10y swap spreads
moving negative. Oddly, the tight level of swap spreads is a look back
into the future. But the inversion of spreads is the new twist.
conclusion is that, independently of our concerns, US Treasury rates are
about to spike. To be sure, MS has been pushing for high rates and major
curve steepending for a while: recall it is their call that the 10 Year
will hit 5.5% this year.
The issuance of
UST debt is dwarfing Libor-related issuance. For example, we expect
UST net issuance to be $1.7Tr and net issuance of MBS to be zero.
Thus, the relative issuance of UST’s vs. Libor-based products mainly
accounts for the inversion in swap spreads. This is a
first sign of stress leading to higher UST yields and is not to be
And back to our
question: is there currently a massive P&L hit to some or
all of the Big 5 US banks as a result of this very much unexpected
inversion? While surely the full $154 trillion or so amount
is not applicable to the 7Y+ inversion, the OCC as of its most recent
report does indicate that there is $27 Trillion in Interest Rate swaps
outsanding with a maturity greater than 5 years.
And when looking
at IR holdings by bank, it would seem that JPM, Goldman, Bofa, and Citi
are most impacted. While JPM, GS, BofA, Citi and Wells have
about $131 billion in IR swaps among them, more relevantly,
JPM, Goldman and BofA have $9, $7 and $5 trillion in >5 year IR swaps.
This is very troubling.
Maybe some of
those fantastic financial analysts who were telling the general public
to buy Lehman a few days before its bankruptcy, and are now saying
financial companies will quadruple over the next few years, can do
something useful for a change and ask the executive teams of the above
mentioned banks 1) how big their exposure to negative swap
spreads is and 2) what the negative P&L impact as a result of this
unprecedented spread inversion is?
As a result of a surge in interest rate and Forex contracts, dependency
on revenues from these products has increased substantially and has in
turn been a source of considerable volatility to total revenues. As of
2Q-09 combined trading revenues (cash and off balance sheet exposure)
from Interest rate and Forex for JP Morgan stood at $2.4 trillion, or
9.5% of the total revenues while the same for GS and BAC (subscribers,
Swap exposure_011009 2009-10-15
stood at $(196) million and $433 million, respectively. As can be seen,
Goldman's trading teams are not nearly as infallible as urban myth makes
them out to be.
According to Moody's, Texas accounts for 17 percent of all swaps in
state and local government, and the investments are preventing a wave of
refinancing at today's rock-bottom interest rates.
Starting in the early 2000s, they became popular with cities, school
districts and state agencies, in part because investment firms marketed
them so effectively. For several years, they worked great, saving
millions in interest for taxpayers. But that changed after the credit
markets imploded and Lehman Bros. failed, triggering downgrades on
municipal bond insurers, counterparty banks and borrowers.
New York state, for instance, reported losing $23 million in interest
and $79 million in terminations last year because of swaps. That was
offset by $143 million in savings in previous years, but today's hits
are coming when local governments face declining budgets.
The Service Employees International Union, whose members include
government workers, says strapped cities nationwide are paying $1.25
billion in charges from the swaps.
States and localities
have also turned to unregulated derivatives to lower borrowing costs and
generate cash to close budget deficits. Many of the contracts had to be
unwound at a cost of billions of dollars because the floating-rate debt
they were hedging was affected when bond insurers lost their top credit
“You combine difficult
financial circumstances with some of these complex issues of valuations
or assessing liabilities, and that contributes to our conclusion that
this is an area worthy of specialized focus,” Robert Khuzami, the SEC’s
director of enforcement, said in a telephone interview.
you thought taxpayers were done funding payouts for Wall Street,
Sunday's New York Times ran an article blowing the lid off a Wall
Street scheme called "interest rate swaps" that are sucking money
from cities and states across the country. The swap deals were
originally sold to communities as a way to shield against
unpredictable interest rates. But, when the banks crashed the
economy, the rules of the game changed.
Now, all these swap deals are
doing is generating pure profit for the big banks - and it's being
paid for with our tax dollars.
These swaps deals amount to the biggest Wall Street bailout you've
never heard of - around $28 billion nationwide. The city of
Oakland, CA alone is paying $5.2 million annually for a swap deal
with Goldman Sachs. That's enough to completely resolve the city's
outstanding budget gap - and avoid cuts to critical services.
Instead, it's being used to fill Goldman's profit pool, while city
services go on the chopping block.
Taxpayers have already given enough to bailout Wall Street. But
that hasn't stopped them from taking more. With communities
feeling the squeeze in a tough economy, the last thing we can
afford to do is send billions of our local tax dollars to Wall
The 10-year swap rate fell more than 2 basis points below the yield
on government paper, after closing 3bps above the Treasury note on
Monday. In late afternoon trade, the 10-year swap rate was 3.655 per
cent, while the 10-year note yielded 3.68 per cent.
Swap rates and Treasury yields have been converging in recent weeks,
driven by high government bond supply, and increased demand by investors
using swaps for meeting long-dated liabilities rather than committing
capital to buying bonds.
Large issuance of corporate debt this week, which is swapped from
fixed coupons to floating rates, has also narrowed the difference
between swap rates and Treasury yields.
“Issuance is huge and a lot of corporate bond deals are being swapped
and no one is fighting the other side of that,” said George Goncalves,
head of fixed income strategy at Nomura.
Analysts say a number of structured derivative trades will cease
paying a coupon should swap rates fall below those of Treasury yields;
this may spark a bout of hedging, which intensifies the negative
relationship between swaps and Treasuries.
In the UK, the current 10-year swap at 3.80 per cent sits below the
10-year Gilt yield of 3.91 per cent.
Historically, yields on government bonds have traded at a discount
to the derivative as swaps are money market instruments whereas
Treasuries reflect triple A sovereign risk. Funding a swap trade over
time is more expensive than Treasuries, but constraints on balance
sheets make it difficult for traders to implement such trades.
On 30 July 1998, Alan Greenspan, then Chairman of the
Federal Reserve argued that: "Regulation of derivatives transactions
that are privately negotiated by professionals is unnecessary." In
October 2008, the now former Chairman grudgingly acknowledged that he
was "partially" wrong to oppose regulation of credit default swaps
(CDS). "Credit default swaps, I think, have serious problems associated
with them," he admitted to a Congressional hearing. His current views on
wider derivative regulation remain unknown though his recent speeches
don’t favor greater regulatory oversight generally. Politicians and
regulators globally are currently busy drafting laws to regulate
derivatives. A common theme underlying the activity is an absence of
knowledge of the true operation of the industry and the matters that
need to be addressed. As Goethe observed: "There is nothing more
frightening than ignorance in action."
Stripped of quantitative hyperbole, derivatives enable traders to take
the risk of the asset without the need to own and fund it. For example,
the purchase of $10 million of shares requires commitment of cash.
Instead, the trader can instead enter a total return swap (TRS) where he
receives the return on the share (dividends
and increases in price) in return for paying the cost of holding the
shares (decreases in price and the funding cost of the dealer). The TRS
requires no funding other than any collateral required by the dealer;
this is substantially less than the $10 million required to buy the
shares. The trader acquires the same exposure as buying the shares but
increases its return and risk through leverage.
Derivative volumes are inconsistent with pure risk transfer. In the CDS
market, volumes were in excess of four times outstanding underlying
bonds and loans. In the currency and interest rates,
the multiples are higher.
Investors searching for return drive speculation
Facing increased pressure on earnings, corporations have increasingly
"financialized,” resorting to speculative derivative trading to meet
Recent experience suggests that in stressful conditions speculators
are users rather than providers of scarce liquidity. Speculative
activity amplifies rather than reduces volatility and systemic risks.
Perversely, this may impede capital formation and also increase the cost
of capital for companies. Current regulatory proposals do not attempt to
deal with speculative activity in the derivatives markets.
Without the possibility for
international investors to hedge their exposure to Greece, refinancing
costs for the Greek state and companies would be higher. Furthermore, by
putting a price on a Greek default, the risk had become tradable,
Ackermann said. But markets would only find acceptance if they were seen
to be "reasonable, fair and orderly," he added. Above all the crisis had
shown a need for "better, qualified" regulators, Ackermann said.
An Italian judge ordered
on Wednesday four international banks to stand trial on charges four
international banks to stand trial on charges stemming from a 2005
derivatives swap for a 1.68 billion euros bond by the city of Milan,
legal sources said.
Buyer's remorse has hit some cities and states that did
deals with Wall Street in different times. Hundreds of U.S.
municipalities are losing money on interest-rate bets they made
during the bull market in hopes of protecting themselves from higher
rates. The deals backfired when rates fell, shriveling the sums paid
to municipalities. Now some are criticizing Wall Street and trying to
exit the contracts.
The Los Angeles city council approved a measure this month
instructing city officials to try to renegotiate an interest-rate deal
Bank of New York Mellon Corp. and Belgian-French bank
Dexia SA. The pact, reached in 2006 to help fund the city's
wastewater system, currently is costing the city about $20 million a
year. The banks declined to say how they would respond to a request to
In Pennsylvania, 107 school districts entered into interest-rate swap
agreements from October 2003 to last June. At least three have
terminated them. Under one deal, the Bethlehem, Pa., school district had
to pay $12.3 million to terminate a swap with J.P Morgan Chase & Co.,
according to state auditor general Jack Wagner. J.P. Morgan declined to
State lawmakers have proposed restrictions on municipalities' ability
to use swaps. "It's gambling with the public's money," Mr. Wagner said.
"Elected officials are simply no match for the investment banker that's
selling the deal."
The Service Employees International Union said Chicago, Denver,
Kansas City, Mo., Philadelphia, Massachusetts, New Jersey, New York and
Oregon all are in the hole on swaps agreements they made with financial
firms. The required payments range from a few million dollars to more
than $100 million a year, the union said.
Such deals are deepening the misery faced by state and local
governments throughout the U.S., already facing their worst financial
squeeze in decades because of shrinking tax revenue and stubbornly high
pensions and other costs.
Government agencies that saw the transactions as a cushion against
fiscal surprises now are being squeezed by the arrangements. The supply
of municipal derivatives swelled to more than $500 billion before
falling in the past two years, estimates Matt Fabian, managing director
at research firm Municipal Market Advisors. Moody's Investors Service
says the surge was fueled by Wall Street marketing efforts, demand from
state and local governments and "relatively permissive" statutes on the
use of swaps in Pennsylvania and Tennessee, both of which are taking
steps to tighten rules.
Many of the deals generated higher fees for securities firms than
traditional fixed-rate debt. Government officials, for their part,
entered the deals in hopes of reducing borrowing costs.
The swaps were introduced in many cases along with floating-rate debt
that municipalities issued because it was cheaper than traditional
fixed-rate debt. Lower interest rates have served them well on this;
their borrowing got cheaper
But municipalities also added swaps to the mix, promising to pay a
fixed rate to banks, often 3% or more, while receiving payments from
banks that vary with interest rates. On the swaps, the municipalities
generally have been losers, as the interest that banks have to pay them
have often fallen below 0.5%.
Government budgets are stretched thin, prompting officials to look
for dollars wherever they can. The clashes over the swaps come amid
growing scrutiny of the municipal-bond market, where the U.S. government
is investigating whether there was bid rigging in certain cases.
Wall Street firms say no one was complaining when the deals were
helping municipalities save. Defenders of swaps say they still can help
cities if paired with the right borrowing strategy.
Some securities-industry officials say they are open to renegotiating
with municipalities so long as doing do doesn't cause a tidal wave of
"If they can't come to an agreement on how to modify, the contract
should stand," said Michael Decker, a managing director at the
Securities Industry and Financial Markets Association, a trade group.
Escaping isn't cheap or easy. Under a transaction between Oakland,
Calif., and a
Goldman Sachs Group-backed venture, Goldman paid the city $15
million in 1997 and $6 million in 2003, according to Oakland financial
reports. But now, the city stands to lose about $5 million this year.
That money "is coming out of taxpayers' pockets and could be used for
other things," said Rebecca Kaplan, a city council member. She wants the
city to renegotiate. But the city faces a $19 million termination
payment. Oakland officials didn't respond to requests for comment.
Some deals have led to court. Last August, a unit of bond insurer
Ambac Financial Group sued the Bay Area Toll Authority for payments
it said it was owed under various swap agreements. The authority paid
Ambac $104.6 million to terminate the swaps after the insurer's credit
ratings were downgraded and bonds associated with the swaps were
retired. Ambac claims it is owed $156.6 million under the agreements.
The toll authority, which is fighting the claim, said it made the
payment, and Ambac sued for the other part of what it says it is owed.
An Ambac lawyer couldn't be reached for comment.
Next month, Richmond, Calif., is expected to restructure a $65
million agreement with
Royal Bank of Canada that could cost the struggling city an
estimated $3.5 million a year, based on current interest rates. Under
the revised deal, Richmond would make smaller, more regular payments to
the bank over time.
In November, RBC and city officials rejiggered a separate transaction
that would have cost Richmond about $2.5 million. An RBC spokesman said
bank officials are working with the city to "restructure the underlying
bonds in a way that best serves the city's interests and those of its
The "goal of the original transaction was to lower borrowing costs
for the city," the bank spokesman said, adding that the bonds didn't
perform s anticipated because of downgrades at bond insurers that backed
Richmond's vice mayor, Jeff Ritterman, said he still is reviewing
next month's proposed restructuring. Financial woes have forced Richmond
to cut its budget and lay off employees.
U.S. municipalities are losing money on
they made during the bull market
in hopes of
protecting themselves from higher rates.
CITY OF LOS
ANGELES versus BNY MELLON
PENNSYLVANIA SCHOOL DISTRICTS
One District alone
had to pay JPM 12.3M to terminate
The relationship between bonds and derivatives in
the UK and the US is being distorted by record government debt issuance,
in a clear sign that massive fiscal borrowing is overwhelming the
In normal market conditions, yields on government bonds, such as
US Treasuries, UK gilts and German Bunds, trade at a discount to swap
rates. This is because swap rates are based on a funding rate that is
linked to the interbank lending market. This rate is higher than the
repo rate used for financing government bonds. Swaps are money market
instruments whereas Treasuries reflect triple A sovereign risk.
However, in the UK 10-year swap rates started trading below
equivalent government bond yields in December while recently in the US
they traded at a record low of just 2 basis points above government
In the UK, the negative relationship persists, with 10-year
government paper at 4.04 per cent and the swap rate at 3.89 per cent.
Swap rates have never fallen below bond yields in the US.
"It's a big story and it has a lot to do with the huge amount of
supply that must be digested by the market," says Alex Li,
strategist at Credit Suisse.
Analysts say the negative spread between swaps and gilts reflects
a combination of rising government bond yields, due to worries over
supply, and falling swap rates as pension funds, in particular, look to
use swaps for meeting long dated liabilities rather than commit capital
to buying bonds.
The UK situation also suggests that the default risk for private
institutions, such as the pension funds and banks that use swaps, is
lower than the UK sovereign risk, despite the state being triple A
rated and having the power to raise taxes.
"It is a strong sign of worries about supply as government bond
yields are in theory still considered risk free, and therefore should
trade below swap rates, which are a reflection of the private markets,"
says Steven Major, head of global fixed income at HSBC.
"I think this narrowing is due to misplaced concerns about
sovereign credit quality in the UK," he adds. However, concerns
about sovereign risk look unlikely to go away, with Moody's warning
yesterday that the US and UK were moving closer to losing their triple A
The theory that swap rates should not trade below Treasury yields
because they present arbitrage opportunities that can be exploited via
the different rates for funding Treasury and money market instruments
has been in doubt since the 2008 financial crisis.
Executing such a trade depends on committing capital for an
extended period, something that has become very difficult in the current
era of balance sheet constraints.
With the demise of Lehman Brothers, US 30-year swap rates fell below
those of 30-year government yields and have remained that way. This
shows the difficulty of financing long term balance sheet trades in an
uncertain financial world. "Some people have been calling for the
10-year spread to get to zero, others are fighting it, but if the
30-year spread can turn negative, the 10-year can follow," says Gerald
Lucas, senior investment advisor at Deutsche Bank.
In the UK, the economic outlook has been complicated by worries over
the Bank of England's decision to put quantitative easing on hold, says
Mr Major. Concerns over a hung parliament (the UK general election is
expected on May 6) have also pushed gilt yields higher.
Another factor in the UK is that pension fund demand has pushed swaps
into negative spread territory, as rather than commit cash to buying
bonds, funds have chosen swaps to lock in long term fixed rates, a
synthetic way of buying a bond and receiving a coupon payment.
In the US, there are indications that much of the US swap market has
been caught out by the lack of a sharp upward move in rates. Traders say
that many structured products based on swaps have been set up in recent
months, designed to profit from a sharp rise in market rates, which to
date have not materialised.
At the start of March, US swap rates were 8.5 basis points above the
10-year Treasury yield. The 10-year swap was trading yesterday at 3.76
per cent, against a 10-year government yield of 3.72 per cent.
"Positioning matters and we could easily see swap rates converge
on Treasury yields based on the fact that people are heavily biased
towards rising rates once the Fed ends it mortgage buying at the end of
the month," says George Goncalves, head of US rates strategy at Nomura
"If we don't see a sharp rise in rates, the swap market will move
much faster than Treasuries as those positions are reversed," he adds.
"I think it's too early to suggest this is a credit issue for the US,"
says John Brady, senior vice-president at MF Global. "It's highly
probable that we see a negative [US] swap spread and it's a clear
example of too much cash chasing too little yield."
Also pressuring the US and UK markets is the expectation of further
corporate issuance. Much of this debt is seen coming from financials, as
they swap the fixed rates of bond payments into floating rate exposure.
That type of swapping activity compresses swap spreads and there are
indications that some dealers have been getting ahead of a swapping
Mr Lucas says: "It reflects a combination of Treasury supply, the
attractiveness of using swaps over cash bonds by some long-term
investors and expectations of strong corporate debt issuance in March."
The relationship between bonds and derivatives in the UK and
is being distorted by record government debt issuance,
in a clear sign that massive fiscal
borrowing is overwhelming the markets.
In normal market conditions, yields on government bonds,
such as US Treasuries, UK gilts and German Bunds,
trade at a discount to swap rates. This is because swap rates
are based on a funding rate that is linked to the interbank lending market.
This rate is higher than the repo rate used for financing government bonds.
Swaps are money market instruments whereas Treasuries reflect triple A
The UK situation also suggests that the default risk for private
such as the pension funds and banks that use swaps,
is lower than the UK sovereign risk, despite the state being triple A rated
and having the power to raise taxes.
The theory that swap rates should not trade below Treasury yields
because they present arbitrage opportunities that can be exploited
via the different rates for funding Treasury and money market instruments
has been in doubt since the 2008 financial crisis.
It's highly probable that we see a negative [US] swap spread and it's a
clear example of too much cash chasing too little yield."
"It reflects a combination of Treasury supply,
the attractiveness of using swaps over cash bonds by some long-term
and expectations of strong corporate debt issuance in March."
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