3 ms·

there is indeed an argument that says that daily mark-to-market (with collateral reconciliation) nullifies all but the very wide tails of the distribution. So t

there is indeed an argument that says that daily mark-to-market (with collateral reconciliation) nullifies all but the very wide tails of the distribution. So the 6-sigma risk is paradoxically increased on daily liquidity, because you're sleepwalking into taking bigger risks, on which big sigmas are never materially manifested......until they are... Basically - we're erasing "normal" counterparty risk in derivatives, in so doing blinding us to big abnormalities. Imagine an ocean with zero waves (ie a pond), until the tidal wave hits. Wouldn't it be better to have some fear of waves hitting you daily, so you're (somewhat more) prepared for "the big one"? Scarily, there are something like 70 trillion of swap contracts outstanding. Someone correct me if I am wrong (though I'd bet I'm underestimating). There is a large and growing body of evidence that huge central bank involvement in markets is increasing exactly such risks and it is an extremely important point. Still... if we consider that you wear the up-to-6 sigma risk with Treasuries (ie 99.999999% of the time - whatever the number of 9s is), but you are spared all but the 6-sigma risks in swaps, then it is probable (though I agree .. not certain), that you're better off with the mark-to-market collateral protection that you get in swaps. Thus the article's main point is erroneous. It is clear that the idea pushed by Bloomberg here, that banks have somehow become better credit quality than the US government, is wrong, as can be seen by a simple look at their equivalent-maturity borrowing rates in the bond market (well above Treasuries). IE: not comparing apples with oranges.

pjmorris 11y ago
> Ts are being printed without even the slightest regard for the (old-fashioned) concept known as fiscal rectitude. > Scarily, there are something like 70 trillion of swap contracts outstanding. I guess there's 15-20T in T's outstanding... if there's 70T in swaps (that don't have a Fed or an army behind them), what would your comment on their 'fiscal rectitude' be?
- vegabook 11y ago
  Here is the perfect opportunity to clarify a misconception. Swaps != debt. Swaps do not create a liability/asset unless interest rates move, and even so, most of the swap contracts will then nullify one another. Most banks admittedly have trillions of notional swaps on their books. The very vast majority of these offset each other. The "open position" (net exposure) in banks is very heavily monitored by the authorities. Banks are not heavily exposed. Arguably, corporates (who hedge) and insurance companies or pension funds DO have open positions in swaps. But even so, recall that the potential liability is proportional to the likelihood of an interest rate move. Let's say an open position of 1 trillion (enormous) receiver swaps (lent) sees a 3% upmove in 5y interest rates on an average 5y maturity of the book (usually lower). Assuming rates near zero which they are, the duration calculation means a net debt becomes payable by such company of 3x5% = 15% of the notional = 150 billion USD. So 1 trillion became 150 billion, even under an extreme scenario. 1/6th. Then recall, that rates will never move 3% (300bps) in one line. They'll move a few bps every day. It'll be very clear once the liability hits, say 5-10 billion, that the counterparty cannot pay anymore, they will be made bankrupt (or close these positions) well before 3% (remember daily margining?), and the swap contracts will become null and void immediately. So now 1 trillion of swap contracts became 5-10 billion realizable debts. By contrast, when the Treasury borrows 1 trillion, they owe a full trillion, no matter what happens in interest rates. See the difference? Now in this analysis, I'm glossing over counterparty risk in swaps. Banks "not heavily exposed" relies on the idea that all banks are good for their commitments, since their netting is done against other banks. This is not the case in a Lehman style scenario(it's like a huge web that even neo4j would have trouble monitoring - ha ha - if a piece of the web falls away, many banks are then potentially exposed). Hence the major focus of all policy makers in the past several years has been to make derivative clearing daily-marginable, and exchange cleared. To erase that problem (outside of 6-sigma "impossible" etc - see one of my other posts) Further to that policy maker regulation, did you know that in the latest European banking sector rules, derivative contract commitments are senior even to small depositors? So equity goes first, then subordinated (higher yield) debt, then depositors > 100k, then senior debt, then depositors < 100k, and only then, swap liabilities. Of course, lawyers sit even above swaps ;-)
  - a-dub 11y ago
    So basically what you're saying is that swaps under these new rules are good as they go south quicker and more obviously in changing market conditions, which forces the hand of the holder to plan ahead and actively hedge their bets elsewhere in real time rather than relying on the long term false security of something that might be rotten underneath?
    - vegabook 11y ago
      Well, swaps will not move south any faster or slower than treasuries, usually, but the former will be a leveraged instrument so will tend to force the holder's hand to close much more quickly. Generally I did not intend my post to exonerate swaps as a dangerous instrument. They are. Just to say that they cannot be equated with outright debt.
      - pjmorris 11y ago
        Nice explanation in the above post... the kind John Merriwether (LTCM) might have given in 1997 or Dick Fuld (Lehman) might have given in 2007. You're certainly right in that there's less than 70T in leverage involved in the swaps, but I think you're also right to call them dangerous.
- deleted 11y ago
  [deleted]

pjmorris 11y ago

> Ts are being printed without even the slightest regard for the (old-fashioned) concept known as fiscal rectitude. > Scarily, there are something like 70 trillion of swap contracts outstanding. I guess there's 15-20T in T's outstanding... if there's 70T in swaps (that don't have a Fed or an army behind them), what would your comment on their 'fiscal rectitude' be?

vegabook 11y ago
Here is the perfect opportunity to clarify a misconception. Swaps != debt. Swaps do not create a liability/asset unless interest rates move, and even so, most of the swap contracts will then nullify one another. Most banks admittedly have trillions of notional swaps on their books. The very vast majority of these offset each other. The "open position" (net exposure) in banks is very heavily monitored by the authorities. Banks are not heavily exposed. Arguably, corporates (who hedge) and insurance companies or pension funds DO have open positions in swaps. But even so, recall that the potential liability is proportional to the likelihood of an interest rate move. Let's say an open position of 1 trillion (enormous) receiver swaps (lent) sees a 3% upmove in 5y interest rates on an average 5y maturity of the book (usually lower). Assuming rates near zero which they are, the duration calculation means a net debt becomes payable by such company of 3x5% = 15% of the notional = 150 billion USD. So 1 trillion became 150 billion, even under an extreme scenario. 1/6th. Then recall, that rates will never move 3% (300bps) in one line. They'll move a few bps every day. It'll be very clear once the liability hits, say 5-10 billion, that the counterparty cannot pay anymore, they will be made bankrupt (or close these positions) well before 3% (remember daily margining?), and the swap contracts will become null and void immediately. So now 1 trillion of swap contracts became 5-10 billion realizable debts. By contrast, when the Treasury borrows 1 trillion, they owe a full trillion, no matter what happens in interest rates. See the difference? Now in this analysis, I'm glossing over counterparty risk in swaps. Banks "not heavily exposed" relies on the idea that all banks are good for their commitments, since their netting is done against other banks. This is not the case in a Lehman style scenario(it's like a huge web that even neo4j would have trouble monitoring - ha ha - if a piece of the web falls away, many banks are then potentially exposed). Hence the major focus of all policy makers in the past several years has been to make derivative clearing daily-marginable, and exchange cleared. To erase that problem (outside of 6-sigma "impossible" etc - see one of my other posts) Further to that policy maker regulation, did you know that in the latest European banking sector rules, derivative contract commitments are senior even to small depositors? So equity goes first, then subordinated (higher yield) debt, then depositors > 100k, then senior debt, then depositors < 100k, and only then, swap liabilities. Of course, lawyers sit even above swaps ;-)
- a-dub 11y ago
  So basically what you're saying is that swaps under these new rules are good as they go south quicker and more obviously in changing market conditions, which forces the hand of the holder to plan ahead and actively hedge their bets elsewhere in real time rather than relying on the long term false security of something that might be rotten underneath?
  - vegabook 11y ago
    Well, swaps will not move south any faster or slower than treasuries, usually, but the former will be a leveraged instrument so will tend to force the holder's hand to close much more quickly. Generally I did not intend my post to exonerate swaps as a dangerous instrument. They are. Just to say that they cannot be equated with outright debt.
    - pjmorris 11y ago
      Nice explanation in the above post... the kind John Merriwether (LTCM) might have given in 1997 or Dick Fuld (Lehman) might have given in 2007. You're certainly right in that there's less than 70T in leverage involved in the swaps, but I think you're also right to call them dangerous.
deleted 11y ago
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