7 ms·

Debt Market Distortions Go Global as Nothing Makes Sense Anymore

109 points by randomname2 11y ago

JumpCrisscross 11y ago
Transaction costs. Investors prefer swaps because they carry lower transaction costs. (When something doesn't make sense in finance, it's almost always transaction costs.) Suppose you're a rates dealer. (Rates dealers buy and sell Treasuries and swaps, amongst other things.) An investor wants to invest at the 10-year rate. Say they insist on getting this in the form of a U.S. Treasury. You must either (a) buy a Treasury on the market or (b) pull one from inventory. No other options. Say, on the other hand, they are open to dealing in swaps. You could hedge this like a Treasury. You can also hedge with another swap. Two options instead of one. Makes your life easier, doesn't it? Dealers always preferred swaps. But investors didn't like taking on the counterparty risk. Dodd-Frank changed that. Now swaps are mutualized. If you take out a swap with JPMorgan and they go kaput, other parties will pool together to make you whole. Less of a difference, in terms of credit quality, between a swap and a Treasury now. Dodd-Frank also made it more expensive to hold Treasuries in inventory. In summary, swaps were always tastier to dealers. Dodd-Frank made them more attractive to investors. At the same time Treasuries became even less fun for dealers. Left hand meets right hand and you get lower fees on swaps with a commensurate shift in net pricing.
- scotch_drinker 11y ago
  I'm curious about Dodd-Frank and the mutualization of swaps. It seems like that could have some serious implications but this isn't something I know enough about. As I understand it, Treasuries have been attractive because no one thinks the US Government is going bankrupt. It sounds like now under Dodd-Frank, people don't care if JPM or the like go bankrupt either (implied guarantee?) Can you suggest avenues for learning more about these changes?
  - tdees40 11y ago
    It's pretty simple really. Swaps are now centrally cleared, so you have to post collateral through a clearinghouse. If on any day, one party cannot settle up on their daily variation margin, the trade is terminated. Compare this to before, when swaps were often un-collateralized, so you might have a huge paper profit on a trade that you'll never actually realize because the counterparty lacks the cash to settle up. So before, you could lose the total amount of your trade, but now you can only lose a day's worth of gain or loss. This is a big improvement, and the risk to the taxpayer is pretty de minimus. Of course the central clearinghouse could default, but that's very unlikely for a variety of reasons (mostly that the central clearinghouse's whole reason for existence is not to default).
- bcohn91 11y ago
  I'm a little confused. Are you saying you can hedge a swap like a Treasury, but can't do the reverse -- hedge a Treasury like a swap? Why would that be the case? Or am I misinterpreting you?
  - scarletham 11y ago
    He's saying that if the investor wants a Treasury, the only way you can sell that to him is with a Treasury. If he's open to a swap, you can sell (write) that contract to him and hedge it with either a Treasury or another swap. The only way to deliver a Treasury is with a Treasury, which you have to track down out of inventory or from another dealer. You can write a swap without having to go through that ordeal. This means lower transaction costs.
    - kal31dic 11y ago
      Its not true though. You can sell it to him, receive on a 10 year swap and borrow the bond from someone else. Or you can buy futures and borrow the bond. And if you can't manage to borrow the bond, failing for a while to deliver to your customer is hardly the end of the world, last I checked.
- carsongross 11y ago
  vegabook comments below that swaps are much more like 24-hour loans than the underlying 10-year loans, so it makes sense that they should trade at a discount due to risk differentials. I don't know the mechanics of swap settlement well enough to understand if that is correct, but it seems plausible.
- kal31dic 11y ago
  That doesn't really follow, because contrary to what you say there is option c) buy ten year note futures. From a transaction cost perspective, that's not too bad, and your argument certainly doesn't in itself explain this move. (You could also buy fives and bonds if the butterfly is appealing). The pricing of a swap didn't first order really reflect credit risk of the swap itself (that effect is small versus what we are discussing here). Because swaps between dealers have long been collateralised with mutual mark to market. It did reflect the fact that LIBOR is rate for an unsecured loan between banks. Possibly the new regime caps how high that might go, but it's really less about LIBOR and more about Treasury funding. Capital requirements and the higher cost of balance sheet as reflected in the repo market must be a starting point. And that's not just a US thing, but is at work in other markets too.
jbssm 11y ago
Finance prediction is just a game of pure chance, a random walk. Thing is, the game is rigged and when the big players loose, we all pay the bill.
- collyw 11y ago
  No idea why this is downvoted. The financial crash seems to provide evidence of it happening. And there have been studies showing monkeys being as good as financial analysts at piking stocks. http://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-can-beat-the-market/ http://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-...
tdees40 11y ago
The language in this is a bit silly: "Nowhere is that more evident than in the U.S., where lending to the government should be far safer than speculating on the direction of interest rates with Wall Street banks." You aren't "speculating on the direction of interest rates with Wall Street banks", you're buying a synthetic rates position that is centrally cleared with daily variation margin. That's not quite US Treasury safe, but it's pretty damn safe.
nugget 11y ago
The most interesting signal I've seen from the world of finance is a number of smart hedge fund managers shutting down their funds over the past few years, stating that fundamental value investing is now impossible as the markets are too controlled by Government policies and intervention. It doesn't seem like this is healthy long-term unless the Government can manage a very soft landing.
- Analemma_ 11y ago
  What a wonderfully self-serving explanation. Here's an alternative one: hedge fund managers are shutting down their funds because people are waking up to the fact that hedge funds are a terrible investment. After the managers take their 2-and-20, hedge funds have lagged the market every year, in both market ups and downs. Funds are trying to slow the rush to the exits by slashing fees (http://www.ft.com/intl/cms/s/0/693d9b74-73f3-11e5-bdb1-e6e4767162cc.html http://www.ft.com/intl/cms/s/0/693d9b74-73f3-11e5-bdb1-e6e47...) to keep more people from going the way of CalPERS, but I don't think it's going to work. There's just too much freely-available evidence that hedge funds aren't worth the fees for what you get. Blaming the government as they turn off the lights is a handy way to get at least something positive out of it though.
  - lintiness 11y ago
    hedge funds on average underperform big bulls and outperform big bears. sharpe ratios matter. maybe mass fund closures signal something more interesting than that calpers is run by geniuses (hint: they aren't).
    - snowwrestler 11y ago
      It will be interesting to see how Warren Buffett's long bet comes out. Just a couple more years: http://longbets.org/362/ http://longbets.org/362/
    - JamesBarney 11y ago
      I'm really curious in this. Would you mind linking me to some papers that compare hedge funds risk adjusted returns versus the index funds, or the market?
ChuckMcM 11y ago
I always find these stories interesting but feel like I get lost when they get into the more arcane levels of derivatives. Here is my question; Given the experience of the Subprime mortgage debacle, and the inherent difficulty of understanding who is holding the liability of these derivatives, why doesn't S&P and Moodys just max out their credit worthiness rating at BBB. Just don't ever let them be A rated, at any level. Would that not "fix" the inversion if people are mistakenly believing that counter party interest swaps are "safer" than Treasuries? I'm really curious about that.
- lintiness 11y ago
  treasuries are always safer than bank credit because the us govt can simply print payment of coupons and maturity. the rest of the stuff in this thread is just nonsense.
- bradleyjg 11y ago
  It's be better to fix the laws and regulations that treat the rating agencies' opinions as true facts about the riskiness of assets (e.g. SMMEA, 7 CFR 240.15c3-1, Basel III, many many etc.) than to apply a band-aid patch at the rating agency level. I'm not even sure the government could legally put in such a requirement as the rating agencies have asserted in litigation that their output is protected speech.
deleted 11y ago
[deleted]
- lintiness 11y ago
  it was so obvious it took 8 years to happen? come on, people.
vegabook 11y ago
This is the second time in a week that we're falling all over ourselves wondering why swaps are through Ts. It's not hard: IRS is collateralized, Treasuries are not. With IRS every 3 (or 6) months, you have to cough LIBOR in order to receive the fixed leg. So essentially your maturity commitment is never greater than that, and indeed, for the vast majority of swaps receivers, mark-to-market collateral adjustments happen daily, so your credit risk is 24 hours! This is not the case for USTs where if you invest for 10 years, you have no clue for every single one of those 10 years if your principal will be repaid, and there is absolutely zero collateral adjustment. Why is this so hard for people to understand? Ts are being printed without even the slightest regard for the (old-fashioned) concept known as fiscal rectitude. Swaps can be printed all day long but if the rates start moving you get paid/have-to-pay every 24-hours for the assumed risk. It follows that Ts are now a much riskier bet than swaps, and indeed, what surprises me, is why it has taken so long for this to be happening.
- carsongross 11y ago
  Why is this so hard for people to understand? Here's why: > swaps are through Ts > IRS is collateralized > cough LIBOR in order to receive the fixed leg > majority of swaps receivers > mark-to-market collateral adjustments Nobody (to a second order approximation) knows what the fuck any of that means, because, since they are sane people with lives to lead, they don't delve into the details of advanced finance.
  - vegabook 11y ago
    let me make it perfectly clear. Lend money for 24 hours is less risky than lend money for 10 years. Does that make sense? On your point about finance being complex. This is Bloomberg writing the story. They of all people should know. And this is the second time in a week that they're pushing this stuff. BTW: for the average finance guy the CS jargon on this site would also qualify as something to be dismissed by "sane people with lives to lead". Not a valid argument. And before you tell me that this is a CS site so that is understandable, I'll ask you why this Bloomberg stuff is making it to Page 1.
o_nate 11y ago
These stories came around a few years ago when swap spreads went negative, and it seems like the same mistakes in interpretation are being made again. Negative swap spreads do NOT imply that big banks are more creditworthy than the US Treasury. That is obviously fallacious. You are comparing apples and oranges. If you want to do a fair comparison, compare the yield on a Treasury bond with the yield on a non-callable bank bond of the same maturity. Guess what? The Treasury yield will be lower. Or if you prefer, look at the CDS market and compare the CDS spread for protection on the US Government vs the spread for any major bank. Again, the US government spread is less. If you want to understand this, you need to think about what kind of arbitrage trade would profit from this situation and why it's not happening in large enough size to reverse this. You'll realize that the operative constraints are not fears about the creditworthiness of the US government.

109 points by randomname2 11y ago

Transaction costs. Investors prefer swaps because they carry lower transaction costs. (When something doesn't make sense in finance, it's almost always transaction costs.) Suppose you're a rates dealer. (Rates dealers buy and sell Treasuries and swaps, amongst other things.) An investor wants to invest at the 10-year rate. Say they insist on getting this in the form of a U.S. Treasury. You must either (a) buy a Treasury on the market or (b) pull one from inventory. No other options. Say, on the other hand, they are open to dealing in swaps. You could hedge this like a Treasury. You can also hedge with another swap. Two options instead of one. Makes your life easier, doesn't it? Dealers always preferred swaps. But investors didn't like taking on the counterparty risk. Dodd-Frank changed that. Now swaps are mutualized. If you take out a swap with JPMorgan and they go kaput, other parties will pool together to make you whole. Less of a difference, in terms of credit quality, between a swap and a Treasury now. Dodd-Frank also made it more expensive to hold Treasuries in inventory. In summary, swaps were always tastier to dealers. Dodd-Frank made them more attractive to investors. At the same time Treasuries became even less fun for dealers. Left hand meets right hand and you get lower fees on swaps with a commensurate shift in net pricing.

scotch_drinker 11y ago
I'm curious about Dodd-Frank and the mutualization of swaps. It seems like that could have some serious implications but this isn't something I know enough about. As I understand it, Treasuries have been attractive because no one thinks the US Government is going bankrupt. It sounds like now under Dodd-Frank, people don't care if JPM or the like go bankrupt either (implied guarantee?) Can you suggest avenues for learning more about these changes?
- tdees40 11y ago
  It's pretty simple really. Swaps are now centrally cleared, so you have to post collateral through a clearinghouse. If on any day, one party cannot settle up on their daily variation margin, the trade is terminated. Compare this to before, when swaps were often un-collateralized, so you might have a huge paper profit on a trade that you'll never actually realize because the counterparty lacks the cash to settle up. So before, you could lose the total amount of your trade, but now you can only lose a day's worth of gain or loss. This is a big improvement, and the risk to the taxpayer is pretty de minimus. Of course the central clearinghouse could default, but that's very unlikely for a variety of reasons (mostly that the central clearinghouse's whole reason for existence is not to default).
bcohn91 11y ago
I'm a little confused. Are you saying you can hedge a swap like a Treasury, but can't do the reverse -- hedge a Treasury like a swap? Why would that be the case? Or am I misinterpreting you?
- scarletham 11y ago
  He's saying that if the investor wants a Treasury, the only way you can sell that to him is with a Treasury. If he's open to a swap, you can sell (write) that contract to him and hedge it with either a Treasury or another swap. The only way to deliver a Treasury is with a Treasury, which you have to track down out of inventory or from another dealer. You can write a swap without having to go through that ordeal. This means lower transaction costs.
  - kal31dic 11y ago
    Its not true though. You can sell it to him, receive on a 10 year swap and borrow the bond from someone else. Or you can buy futures and borrow the bond. And if you can't manage to borrow the bond, failing for a while to deliver to your customer is hardly the end of the world, last I checked.
carsongross 11y ago
vegabook comments below that swaps are much more like 24-hour loans than the underlying 10-year loans, so it makes sense that they should trade at a discount due to risk differentials. I don't know the mechanics of swap settlement well enough to understand if that is correct, but it seems plausible.
kal31dic 11y ago
That doesn't really follow, because contrary to what you say there is option c) buy ten year note futures. From a transaction cost perspective, that's not too bad, and your argument certainly doesn't in itself explain this move. (You could also buy fives and bonds if the butterfly is appealing). The pricing of a swap didn't first order really reflect credit risk of the swap itself (that effect is small versus what we are discussing here). Because swaps between dealers have long been collateralised with mutual mark to market. It did reflect the fact that LIBOR is rate for an unsecured loan between banks. Possibly the new regime caps how high that might go, but it's really less about LIBOR and more about Treasury funding. Capital requirements and the higher cost of balance sheet as reflected in the repo market must be a starting point. And that's not just a US thing, but is at work in other markets too.

jbssm 11y ago

Finance prediction is just a game of pure chance, a random walk. Thing is, the game is rigged and when the big players loose, we all pay the bill.

collyw 11y ago
No idea why this is downvoted. The financial crash seems to provide evidence of it happening. And there have been studies showing monkeys being as good as financial analysts at piking stocks. http://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-can-beat-the-market/ http://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-...

tdees40 11y ago

The language in this is a bit silly: "Nowhere is that more evident than in the U.S., where lending to the government should be far safer than speculating on the direction of interest rates with Wall Street banks." You aren't "speculating on the direction of interest rates with Wall Street banks", you're buying a synthetic rates position that is centrally cleared with daily variation margin. That's not quite US Treasury safe, but it's pretty damn safe.

nugget 11y ago

The most interesting signal I've seen from the world of finance is a number of smart hedge fund managers shutting down their funds over the past few years, stating that fundamental value investing is now impossible as the markets are too controlled by Government policies and intervention. It doesn't seem like this is healthy long-term unless the Government can manage a very soft landing.

Analemma_ 11y ago
What a wonderfully self-serving explanation. Here's an alternative one: hedge fund managers are shutting down their funds because people are waking up to the fact that hedge funds are a terrible investment. After the managers take their 2-and-20, hedge funds have lagged the market every year, in both market ups and downs. Funds are trying to slow the rush to the exits by slashing fees (http://www.ft.com/intl/cms/s/0/693d9b74-73f3-11e5-bdb1-e6e4767162cc.html http://www.ft.com/intl/cms/s/0/693d9b74-73f3-11e5-bdb1-e6e47...) to keep more people from going the way of CalPERS, but I don't think it's going to work. There's just too much freely-available evidence that hedge funds aren't worth the fees for what you get. Blaming the government as they turn off the lights is a handy way to get at least something positive out of it though.
- lintiness 11y ago
  hedge funds on average underperform big bulls and outperform big bears. sharpe ratios matter. maybe mass fund closures signal something more interesting than that calpers is run by geniuses (hint: they aren't).
  - snowwrestler 11y ago
    It will be interesting to see how Warren Buffett's long bet comes out. Just a couple more years: http://longbets.org/362/ http://longbets.org/362/
  - JamesBarney 11y ago
    I'm really curious in this. Would you mind linking me to some papers that compare hedge funds risk adjusted returns versus the index funds, or the market?

ChuckMcM 11y ago

I always find these stories interesting but feel like I get lost when they get into the more arcane levels of derivatives. Here is my question; Given the experience of the Subprime mortgage debacle, and the inherent difficulty of understanding who is holding the liability of these derivatives, why doesn't S&P and Moodys just max out their credit worthiness rating at BBB. Just don't ever let them be A rated, at any level. Would that not "fix" the inversion if people are mistakenly believing that counter party interest swaps are "safer" than Treasuries? I'm really curious about that.

lintiness 11y ago
treasuries are always safer than bank credit because the us govt can simply print payment of coupons and maturity. the rest of the stuff in this thread is just nonsense.
bradleyjg 11y ago
It's be better to fix the laws and regulations that treat the rating agencies' opinions as true facts about the riskiness of assets (e.g. SMMEA, 7 CFR 240.15c3-1, Basel III, many many etc.) than to apply a band-aid patch at the rating agency level. I'm not even sure the government could legally put in such a requirement as the rating agencies have asserted in litigation that their output is protected speech.

deleted 11y ago

[deleted]

lintiness 11y ago
it was so obvious it took 8 years to happen? come on, people.

vegabook 11y ago

This is the second time in a week that we're falling all over ourselves wondering why swaps are through Ts. It's not hard: IRS is collateralized, Treasuries are not. With IRS every 3 (or 6) months, you have to cough LIBOR in order to receive the fixed leg. So essentially your maturity commitment is never greater than that, and indeed, for the vast majority of swaps receivers, mark-to-market collateral adjustments happen daily, so your credit risk is 24 hours! This is not the case for USTs where if you invest for 10 years, you have no clue for every single one of those 10 years if your principal will be repaid, and there is absolutely zero collateral adjustment. Why is this so hard for people to understand? Ts are being printed without even the slightest regard for the (old-fashioned) concept known as fiscal rectitude. Swaps can be printed all day long but if the rates start moving you get paid/have-to-pay every 24-hours for the assumed risk. It follows that Ts are now a much riskier bet than swaps, and indeed, what surprises me, is why it has taken so long for this to be happening.

carsongross 11y ago
Why is this so hard for people to understand? Here's why: > swaps are through Ts > IRS is collateralized > cough LIBOR in order to receive the fixed leg > majority of swaps receivers > mark-to-market collateral adjustments Nobody (to a second order approximation) knows what the fuck any of that means, because, since they are sane people with lives to lead, they don't delve into the details of advanced finance.
- vegabook 11y ago
  let me make it perfectly clear. Lend money for 24 hours is less risky than lend money for 10 years. Does that make sense? On your point about finance being complex. This is Bloomberg writing the story. They of all people should know. And this is the second time in a week that they're pushing this stuff. BTW: for the average finance guy the CS jargon on this site would also qualify as something to be dismissed by "sane people with lives to lead". Not a valid argument. And before you tell me that this is a CS site so that is understandable, I'll ask you why this Bloomberg stuff is making it to Page 1.

o_nate 11y ago

These stories came around a few years ago when swap spreads went negative, and it seems like the same mistakes in interpretation are being made again. Negative swap spreads do NOT imply that big banks are more creditworthy than the US Treasury. That is obviously fallacious. You are comparing apples and oranges. If you want to do a fair comparison, compare the yield on a Treasury bond with the yield on a non-callable bank bond of the same maturity. Guess what? The Treasury yield will be lower. Or if you prefer, look at the CDS market and compare the CDS spread for protection on the US Government vs the spread for any major bank. Again, the US government spread is less. If you want to understand this, you need to think about what kind of arbitrage trade would profit from this situation and why it's not happening in large enough size to reverse this. You'll realize that the operative constraints are not fears about the creditworthiness of the US government.