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Swaps turn negative

Swap spreads turn negative
By Michael Mackenzie in New York
Published: October 23 2008 23:52 | Last updated: October 23 2008 23:52
The turmoil in the financial markets has taken hold of the strategically important trade in long-term interest rate derivatives, pushing rates to levels once thought to be a “mathematical impossibility”.

Such interest rate swaps are the most widely traded over-the-counter derivative and are crucially important for insurers, pension funds and other companies that need to fund liabilities decades into the future.

Investors use swaps to lock in interest rates for 30 years or more, trading a floating rate, based on the London interbank offered rate, for a fixed rate, typically based on US Treasury yields, plus a premium, called the swap spread, which reflects the risk of trading with a private counterparty as opposed to the government.

On Thursday, the 30-year swap spread turned negative after briefly flirting with such levels earlier this month. This implies investors are somehow reckoning that they are more likely to be paid back by a private counterparty than by the government.

I won't even pretend to understand exactly what this might mean or portend... but it sounds bad.

wisconsin_cur wrote:...I won't even pretend to understand exactly what this might mean or portend... but it sounds bad.

That's a huge part of the problem. Very few people understand this crap, and many who think they do actually don't.

These "sophisticated financial instruments" are the work of true mad scientists, many of whom, it turns out, had a less-than-perfect understanding of what their monstrous creations would do.

Zardoz wrote:

wisconsin_cur wrote:...I won't even pretend to understand exactly what this might mean or portend... but it sounds bad.

That's a huge part of the problem. Very few people understand this crap, and many who think they do actually don't.

These "sophisticated financial instruments" are the work of true mad scientists, many of whom, it turns out, had a less-than-perfect understanding of what their monstrous creations would do.

according to mandelbrot and mr. black swan, that's it in a nutshell. the system is so complex that it is simply not predictable--anything can happen. the monster has decoupled from the creator and is perfectly capable and willing to bite his head off.

The Lehman bankruptcy is important because it led to the termination of outstanding contracts. With many participants scaling back activities, investors have had trouble filling holes in their portfolios, upsetting the normal relationship between the swap spread and the “risk-free” Treasury yield.

For much of this year, the 30-year swap spread averaged between 30 and 55 basis points over the 30-year Treasury yield. It closed at 15bp on Monday, 0.5bp on Tuesday and a “negative” 4.25bp on Thursday. Implied 30-year swap spreads for Europe and the UK have been negative since the demise of Lehman.

“Insurance companies and pension funds woke up and realised that their existing swap contracts had been torn up and that they needed to replace them,” said William O’Donnell, UBS strategist.

I do not have the experience to know if this is BS or not.

Zardoz wrote:

wisconsin_cur wrote:...I won't even pretend to understand exactly what this might mean or portend... but it sounds bad.

That's a huge part of the problem. Very few people understand this crap, and many who think they do actually don't.

These "sophisticated financial instruments" are the work of true mad scientists, many of whom, it turns out, had a less-than-perfect understanding of what their monstrous creations would do.

I believe the people who manufactured them perfectly understand them, and fully knew it was a complicated way to steal money and let the bill come later.

Zardoz wrote:

wisconsin_cur wrote:...I won't even pretend to understand exactly what this might mean or portend... but it sounds bad.

That's a huge part of the problem. Very few people understand this crap, and many who think they do actually don't.

These "sophisticated financial instruments" are the work of true mad scientists, many of whom, it turns out, had a less-than-perfect understanding of what their monstrous creations would do.

Including our dear friend Alan Greenspan, who now admits to having made a "mistake" based on fauty mathematical models:

http://www.nytimes.com/external/idg/200 ... n-Bad.html

Reverse Engineer

Simple is good, repeat after me:

"I got horny as a goat with money fever, I dove into a big
whopper of a scam and BS fantasy, and I hurt myself and
everyone I know and I am finding it almost impossible to
admit it. I even begged the government to look the other
way because I thought I was getting rich and didn't
want them to stop me. I would like to help myself but
I don't trust me and I am not sure I ever will again."

Now isn't that better already?

Zardoz wrote:These "sophisticated financial instruments" are the work of true mad scientists, many of whom, it turns out, had a less-than-perfect understanding of what their monstrous creations would do.

It's funny that everyone was worried that the physicist at the LHC might create a black hole that would destroy the planet. They should have been worried about the physicists who left the scientific field to go work on wall street. They actual did manage to create a financial black hole by messing around with derivatives and now it's sucking in everything around it.

wisconsin_cur wrote:I won't even pretend to understand exactly what this might mean or portend... but it sounds bad.

It means that the U.S. Government is acting as guarantor to trillions of dollars worth of trash debt. It is accumulating additional debt at a prodigious rate. Foreign governments may not be willing or able to continue supporting U.S. Government spending.

Therefore, some believe the U.S. Government could default on its sovereign debt.

Increased negative spreads suggests that traders regard the possibility of such a default as having increased.

Jack
I take it that defaulting on your debt is bad. Especially when you are a country. People quit lending to you. You have to live within your means. Entitlements get cut, military gets scaled back.

Fishman wrote:Jack
I take it that defaulting on your debt is bad. Especially when you are a country.

Maybe, do you think just MAYBE????? Christ almighty I get really fucking tired of being embarrassed of my countrymen. When is the reset button going to be pressed? Soon?

Jotapay wrote:

Fishman wrote:Jack
I take it that defaulting on your debt is bad. Especially when you are a country.

Maybe, do you think just MAYBE????? Christ almighty I get really farking tired of being embarrassed of my countrymen. When is the reset button going to be pressed? Soon?

Honestly what amazes me the most is the shortsightedness of most people. I mean seriously, many many people seem to see the sudden rise of the Dollar for example as a GOOD thing.

This morning on the radio (still half asleep) they had a guy on who claimed this was good for Canada, it means goods can be exported, people will come up more (like in the good old days) and spend money etc.

None of them seems to ask about the underlying principle. Much like much of the World (and US particularly) was addicted to cheap credit, so was Canada (and still is) addicted to a cheap Canadian Dollar. It seems NOBODY has realized yet that nobody will be able to afford the trip up north (even if it is dirt cheap) or the car made in Windsor.

Even "funnier" is that there are STILL people up here who claim that the housing market is fine, the funniest being a piece today where finally someone admitted that the market will go down, but they are still thinking only until the end of 2010 and then it will go up again.

Anybody got some room in their bunker? I can bring cans.

What implications does this have for the next Fed Auction?

Problem is most people are sitting in front of their computer in a warm room with a nice beverage and a full stomach. They can't imagine that tomorrow could be anything but the same.

Most will be left wondering why the grocery store didn't have their favorite food for long enough to notice and why everything is so damn expensive or unavailable before they even consider it.

By then it will be too late, as everyone will be in the same boat.

Fishman wrote:Jack
I take it that defaulting on your debt is bad. Especially when you are a country. People quit lending to you. You have to live within your means. Entitlements get cut, military gets scaled back.

In addition, imports require actual cash instead of credit or a debased currency. Then the rather pampered public experiences a sudden introduction to hardship. They then behave badly.

Jack wrote:Then the rather pampered public experiences a sudden introduction to hardship. They then behave badly.

And Jack will be there!

wisconsin_cur wrote:Swaps turn negative

Swap spreads turn negative
By Michael Mackenzie in New York
Published: October 23 2008 23:52 | Last updated: October 23 2008 23:52
The turmoil in the financial markets has taken hold of the strategically important trade in long-term interest rate derivatives, pushing rates to levels once thought to be a “mathematical impossibility”.

Such interest rate swaps are the most widely traded over-the-counter derivative and are crucially important for insurers, pension funds and other companies that need to fund liabilities decades into the future.

Investors use swaps to lock in interest rates for 30 years or more, trading a floating rate, based on the London interbank offered rate, for a fixed rate, typically based on US Treasury yields, plus a premium, called the swap spread, which reflects the risk of trading with a private counterparty as opposed to the government.

On Thursday, the 30-year swap spread turned negative after briefly flirting with such levels earlier this month. This implies investors are somehow reckoning that they are more likely to be paid back by a private counterparty than by the government.

I won't even pretend to understand exactly what this might mean or portend... but it sounds bad.

It is pretty simple really. Some swaps like options are done under ISDA standard documentation. Money market swaps including repos are done under ISMA standard documentation. Standard documentation means that you have two documents. One is your ISMA or ISDA that covers 99% of whatever will happen. It is based on past experience including previous crises. The confirmation on the other hand refers to the ISMA/ISDA, but lays out deal-specific details. It covers what I would call commercial risk versus legal risk 9 times out of ten.

As a default provision - the lawyers from dozens of investment banks sit around the table and hammer these argreements out - is LIBOR. The London Interbank Offered Rate that is published by the British Bankers Association (BBA). In normal times (at least up to now) this was a reliable indicator of where banks were lending to one another. They discarded the high and low offers, and then calculated the mathmetical mean of the rest of the submitted offers. This was fixed and published daily. As it was so reliable it found its way into standard agreements like ISMA/ISDA as this was something that lawyers could agree on.

So fast forward to this crisis. It breaks down because banks are reluctant to publish what appears to be a negative appraisal of where they are really getting interbank funding. Libor plus a spread that was getting wider. Worse, after Lehman, the lending disappeared, so in essence you had no reference rate. But thousands and thousands of contracts relied on some reference rate being published. Obviously if you are long or short it matters a great deal whether the rate accurately reflects actual deals being done or just a number out of thin air.

The fact is that banks - now - are quoting spreads based on where they can realistically get funding, but all the legacy contracts still refer to a rate that for all intents is meaningless. This is throwing all the mathmetical models off that calculate spreads and chances of defaults. We are talking about fat tails and events that statistically should not happen. There was no malintent. These standard agreements were negotiated in good faith with much, much open dialogue.

The reality is that the future does not always look like we expect it to. Stuff happens. No legal contract is ever 100% water tight. Certainly not a standard agreement that covers thousands of deals and is supposed to cover all eventualities. No agreement ever will. But one has to weigh the thousands of deals that were successfully transacted without any problem against the problems now when those terms may not reflect actual market conditions. It is like not giving out any home loans or mortgages - ever - because now we find out some were poorly written.

MrBill wrote:The fact is that banks - now - are quoting spreads based on where they can realistically get funding, but all the legacy contracts still refer to a rate that for all intents is meaningless. This is throwing all the mathmetical models off that calculate spreads and chances of defaults. We are talking about fat tails and events that statistically should not happen. There was no malintent. These standard agreements were negotiated in good faith with much, much open dialogue.

The reality is that the future does not always look like we expect it to. Stuff happens. No legal contract is ever 100% water tight. Certainly not a standard agreement that covers thousands of deals and is supposed to cover all eventualities. No agreement ever will. But one has to weigh the thousands of deals that were successfully transacted without any problem against the problems now when those terms may not reflect actual market conditions. It is like not giving out any home loans or mortgages - ever - because now we find out some were poorly written.

Yeah, but ...

isn't the problem that people were making contracts that in total grossly exceeded the value of goods and services in the real world? Did they have any way of knowing they were so over-leveraged? And at some point somebody would have to deliver the goods. I think your "fat tail" is just where the Ponzi scheme goes bust.

It is two separate issues:

Leverage and the size of the outstanding positions on one hand;

and the reference rates and how the contracts for differences are calculated on the other.

Although at the moment we are seeing one exacerbate the other as not only is the size of the outstanding positions enormous, but legal risk is adding to the uncertainty of the value of the contracts and who owes what to whom.

During the Russian crisis the Russian government just declared all NDF contracts null & void. Its interpretation was that contracts for differences is gambling and not enforceable. The practical implication was that NDF contracts outside of the Russia were also declared force majeure as there was no longer a published reference rate from the Russian currency exchange against which the outstanding contracts could be settled.

After every crisis we get better at tightening up the legal language, but as I said earlier they can never be 100% water tight and foresee every eventuality. Probably why early in this crisis we saw a flight to simplicity and saw players shunning anything complicated that was hard to price.

My greatest fear is that after this crisis that there will be a push to over-regulation that is also going to strangle legitimate hedging and risk mitigation, while driving up the cost for all sorts financial products. You may say, good, but it will hurt such products as ETFs that many individuals use as investment vehicles as well. The cost of everyday mortgages will certainly rise too as the ABS/MBS markets become a lot smaller and more sensitive to risk (i.e. less liquid).