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.
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.
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?
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.
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.
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?
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).
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.
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.
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.
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.
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.
If there's any chance of a treasury default or other disruption, what happens the next day when nobody wants to be left holding the bag? Seems like in a scenario where something is up, daily liquidity is more dangerous.
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.
> 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?
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.
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?
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.
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.
Tomorrow a buck is worth about a buck. Given some nice 70s era stagflation, in a decade a buck might only be worth fifty cents. Loaning one dude a buck and getting fifty cents back isn't all that different than loaning out ten dimes and getting only five paid back.
There is also downside risk. Your financial life will be about the same tomorrow as it is today, so I can reasonably estimate the odds of getting a buck back if you need change for the vending machine or whatever. Ten years from now, well, hard to say how many bad things can happen to someone in ten years.
Agreed. But lending to a riskier counterparty for 24 hours is usually going to command a lower risk premium than lending to anybody, even the US government, for 10 years. That's the essence of the story here. You make a valid point though: until now it has been riskier even to lend for 24 hours to a bank because of the binary nature in which banks go bust: they're solvent until they're not, and the run can happen in an event-wise, unpredictable fashion.
The real story then is that even taking into account this high banking-sector risk, the US government is now riskier. But this has much more to do with the unlimited printing of debt (the real story) than the IRS market swap spread, and my wider point is that daily margining has been ignored by many of the people (here and in the financial markets chatter) who are talking up this issue as some kind of rubicon moment. This has been in the making for years and the slow grind below zero is not something that should be seen as extraordinary, nor, given the aforementioned slow grind lower, should it come as any surprise that it can go negative.
> But this has much more to do with the unlimited printing of debt (the real story) than the IRS market swap spread
I don't get how U.S. debt is the driving factor. The rate of federal net debt growth has actually been slowing over the past ~3 years as the federal deficit has shrunk, i.e. the arrow is pointed in the right direction.
He's making the case that the simple fact that a Treasury can have a 10-year term makes it riskier than a swap that is marked to market every 24 hours.
This might be a makeable case, but just comparing the terms is not enough to do so. And, while he is using it to explain why Treasuries seem to have a risk premium now, it doesn't explain why they did not previously. Did swaps just start being m2M every 24 hours? Certainly there has been no major change to the nature of Treasuries over the past few months. So why the sudden shift?
vegabook, I encourage you to make a non-hostile comment explaining in plain english how swaps are much closer to 24 hour loans than the underlying securities. This is a good explanation and deserves to be near the top of the comments on this article.
The jargon and tone of your original comment is the reason it is being down voted.
apologies. It's not obvious because the jargon is opaque (though I still question why, if it's not understood, it's upvoted to page 1).
In swaps, as the word suggests, you must pay (the prevailing short-term interest rate) every few months for the right to receive a pre-agreed (long term) interest rate. The key is that you must pay, and if your counterparty does not pay, you will not pay either. So you have a much lower credit risk than an outright lending of money since if the counterparty starts failing, you can stop paying. Sure there is still some credit risk, but it's nowhere near as high as it would be to lend money for 10 years "naked". And since the crisis, moreover, we have "daily margining", that is, if you win in any 24 hour period, your counterparty must pay your winnings. If he doesn't you can cancel the contract. That's much lower risk than betting on repayment with no feedback, for 10 years.
I'm just generally quite "surprised" that this stuff is coming out of Bloomberg who should know better.
I think perhaps you aren't looking at this clearly, because with a swap you have exposure to forward credit spread premium - the market's implied expectations about where LIBOR will be versus the rate from the near risk free overnight rate curve. In 2008 this blew out, and in spite of institutional changes, it's still possible that one day this might happen again.
So you do in fact have a long term exposure to forward credit quality, just as you do with UST, except that the clearing house has no taxing power and cannot print money.
The primary deficit is shrinking, whatever one may think of Mr Obama - and that's hardly surprising when you look at unemployment. So your claim about causality requires further articulation.
It's also not the case that a UST position is not collateralised. If I sell short 100 mm tens, and I borrow these on the market against cash collateral from my receipt from the sale then if the price drops 10 points I get that back in my bank account - just as with a cleared swap position.
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.
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.
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.
"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.
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.
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.
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-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.
I totally agree with your take on the hedge fund industry as a whole. I probably should have clarified. I was speaking specifically about a very small group, like Michael Burry and Gary Schilling, who I admired for their outspoken and transparent economic trend analysis.
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).
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?
Well, given that they're in a position of having to shut down, if they're going to give any explanation at all, it seems unlikely that that explanation would ever be anything along the lines of "We're not very good at this" or "No one wants our product any more". Of course it's going to be someone else's fault..
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.