Tuesday, June 2, 2009

What’s going on in the interest-rate swaps market?

Posted on Reuters by Felix Salmon:

Nemo asks for a translation of this post from John Jansen. There’s a lot to unpack, so let’s just do the first bit:

Swap spreads are still under pressure. One derivatives veteran offered the interesting observation that the GM bankruptcy had led to the spread widening. The GM filing would have negated existing swap contracts. GM is (was) an active issuer and probably had been receiving from the street as they turned fixed rate issuance into floating rate debt.

With the bankruptcy filing those trades no longer exist and the street is left paying no one. Ergo the street is long. They have to pay swaps to hedge the exposure of that legally created long position.

The first thing to grasp here is the ubiquity, in financial circles, of the interest-rate swap, where you can turn an income stream from fixed-rate into floating-rate or vice versa. Let’s say that GM issues a 3-year bond at 8% per year: it might then go along to an investment bank and swap that 8% coupon payment into say Libor plus 400 basis points. Essentially the bank commits to making all those 8% coupon payments, while GM now commits to making payments which fluctuate according to prevailing interest rates.

With interest rates low, GM was actually making money on these swaps: the banks would pay it the difference, every six months or so, between the higher fixed rate and the lower floating rate. But now that GM is bankrupt, the swaps have been torn up, and all those future payments which the banks were expecting to make no longer have to be made.

Of course, banks always hedge their positions — which means that some other counterparty will continue to pay them the money they were expecting to have to pay to GM. That’s what Jansen means when he says that the bank “is long”. Now that money isn’t going to GM, the bank will want to hedge its new long position, which essentially means selling that cashflow in the swap market.

A cashflow is like a bond, and when you sell bonds their yields rise. Similarly, here, when a bank hedges its new long position, yields — which in this case are swap spreads — go up. That’s what Jansen means when he says they’re “under pressure”. (A swap spread is the difference between the yield on the cashflow the bank is selling, and the yield on Treasury bonds of the same maturity.)

What we’re seeing in this case is essentially the inverse of what happened after Lehman declared bankruptcy: in that case the street was short, and swap spreads went down sharply. On the other hand, as Jansen says today, the activity in swap spreads might have nothing to do with GM at all: it might rather be a function of negative convexity (don’t ask) or “hedging of exotic non inversion notes” (ditto).

The market in interest-rate swaps is enormous — orders of magnitude greater than the market in credit default swaps — and, like most markets, it’s done some pretty crazy things over the past year, with long-dated swap spreads going negative for most of that time. Because there aren’t any systemic implications of things like negative long-dated swap spreads, and because the swaps market is a zero-sum game where for every winner there’s an equal and opposite loser, policymakers and bloggers and pundits haven’t paid much attention to it. That’s fine, they don’t need to. But it’s really important for fixed-income traders, which is why the likes of Jansen spend a lot of time looking at it.

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