UPDATE: June 10, 2009 4:14 PM (emphasis mine) [my comment]
I moved the article "THE HORROR, Bond traders are white with terror" to my next entry, *****Treasury Yields Accelerating Upwards*****. I also expanded the conclusion to this entry.
Financial Sense reports about the US "carry trade" economy.
(emphasis mine) [my comment]
Government Playing "The Carry Trade"
The U.S. government's outstanding debt of $7.3 trillion is mainly short-term. On average, federal debt has a maturity of five years or less [Today the average is maturity is four years or less].
Nearly [over] one-third of this debt will come due in less than a year. By keeping its debt short-term, the government has been able to realize a net decline of 13.4 percent per annum in net interest payments. Instead of being prudent and locking in low interest rates, the government has shortened its debt in order to reduce interest rate expense. While this may save money in the short-term, it could also backfire and raise expenses over time as rates begin to rise. Instead of locking in its debt costs, the government is now subject to the vagaries of the debt markets. The trend in interest rates is up, which means the cost of financing all of that short-term debt will also be rising. This will lead to even higher deficits as rising rates slow down the economy, shrink government tax revenues, and increase its expenses. The U.S. government in effect is playing the "Carry Trade" by financing long-term commitments with short-term debt.
Corporate America Playing "The Carry Trade"
Just as the government is short on its debt and long on its expenses, the same mistake is being repeated in the corporate sector. Contrary to popular opinion, the corporate balance sheet has hardly improved. Debt to equity ratios look better thanks to a rising stock market. However, those ratios could deflate as quickly as you can say the word "crash." Recent evidence this year points to a record pace of debt issuance with most of that debt carrying a "floating' rate interest. This debt gets more expensive as interest rates rise. If rates continue to climb as they are now, corporate profits could get squeezed.
According to Lehman Brothers, companies worldwide are set to issue more than $1 trillion in floating rate debt this year. Floating rate debt issuance by investment grade companies is up 36% this year. Companies with junk bond ratings are also issuing floating rate debt. The last time there has been this much variable rate financing was back in 1994.
In addition to issuing variable rate debt, companies are taking on increasing risk with derivatives. Companies issuing longer-term debt are changing the nature of that debt through interest rate swaps. Between 40-50% of newly issued, long-term debt has been swapped. Interest-rate swaps involve the exchange of coupon payments—one fixed and the other floating rate. The interest rate payments are usually paid semiannually. In a swap arrangement, the company agrees to pay the floating rate to its counterparty. This rate is usually the six-month London Interbank Offering Rate or Libor. If rates rise, interest expense rises and companies could find it difficult to reverse such transactions. Most swaps trade over the counter rather than on exchanges, which makes them less liquid.
According to Raj Dhanda, Morgan Stanley's head of global debt syndicate, about half of all U.S. corporate debt is floating rate. This makes the corporate sector vulnerable to rising interest rates more so than in the past since debt levels today are much higher.
According to Standard & Poor's, companies have only marginally reduced debt from 52.7% in 2000 to 52.5% at the end of 2003. Examining the footnotes of companies ranging from GM, GE, Ford and Wells Fargo to Citigroup reveals that companies have turned to variable rate debt to reduce borrowing costs [All these companies are dead meat]. Although companies don't like to reveal how much of their debt is variable, they oftentimes disclose its impact. Citigroup disclosed that pretax earnings could decline as much as $426 million over the next year, if interest rates rose by 1%.
The automobile industry is a big user of variable rate debt and interest rate swaps [which is why GM's bankruptcy is producing interesting results (see next article)]. Ever wonder how auto companies could offer such low finance rates or zero percent car financing? The answer is variable rate debt and interest rate swaps. This is what has driven profits recently at Ford and GM. Ford, which recently reported that second quarter net income tripled to $1.17 billion, made that profit entirely from its Ford Credit unit. The No. 2 auto maker lost money in its core car-making business worldwide. GM's second-quarter earnings were driven almost entirely by a record performance at GMAC (General Motors Acceptance Corporation).
We Are In Denial
The financial markets today are held together by a thin tread of unreality...
Reuters asks what's going on in the interest-rate swaps market?
June 2nd, 2009
What's going on in the interest-rate swaps market?
Posted 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 ["long the bond" = "short the swap" = the floating-rate payers in interest rate swaps = guaranteed annihilation in a hyperinflionary environment]. 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 [However, if rates go up (they will), the flow of money will reverse, and banks will have to start making ever larger payments to that "other counterparty"]. That's what Jansen means when he says that the bank "is long [the bond]". 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.)
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 [Not me, I recognize it as the threat which will bring down the US financial system]. 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.
I wrote about the Interest rate derivates nightmare facing America in my article *****fed planning 15-fold increase in us monetary base*****.
Interest rate derivates nightmare
The threat posed by interest rate derivates is perhaps the greatest out of all the ones outlined so far. It is also the one hardest to understand. The first thing to note about interest rate swaps is the size of the market, as explained by the Wikipedia:
The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC derivative market. The notional amount outstanding as of December 2006 in OTC interest rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005. These contracts account for 55.4% of the entire $415 trillion OTC derivative market. As of Dec 2007 the number rose to 309,6 trillion according to the same source. [As of the second half of 2008, the notional amount of interest-rate derivatives outstanding was $418.7 trillion]
The greater threat posed by interest rate swaps
Besides creating artificial demand for bonds, the interest rate swap market poses a systematic risk exceeding that of the credit-default swap market because of its enormous size and the fact that each interest rate swap contract offers the potential for unlimited losses. The graph below should help show this danger.
In a currency collapse (which is where we are headed with Bernanke's 15-fold increase in the money supply), interest rates follow inflation to astronomical heights. Loans run for 24 hour periods. Interest rates in the five or six digits range are common in hyperinflation, and, should they occur here in the States, anyone "short the swap" (the floating-rate payers in interest rate swaps) will be crushed into oblivion. At least with credit default swaps, there is a limit to how much investors can lose.
My reaction: Interest rates swaps will magnify the damage caused by the dollar's collapse.
1) On average, federal debt has a maturity of four years or less, which means over one-third of this debt will come due in less than a year and need to be rolled over.
2) About half of all US corporate debt is floating rate.
3) Since debt levels today are much higher, the corporate sector is extremely vulnerable to rising interest rates.
4) Since the automobile industry was/is a big user of variable rate debt and interest rate swaps, GM's filing for bankruptcy will negate these existing swap contracts, and leave the street is "long the bond and short the swap".
5) Interest rate swaps offer the potential for unlimited losses. In a dollar collapse, anyone "short the swap" (the floating-rate payers in interest rate swaps) will be crushe d into oblivion.
Conclusions: Rising Treasury Yields are going to wreck massive damage on the US economy.
A dollar collapse will drive interest rates to infinity
Right now, interest rates are only slowly moving upwards. However, once fears of a dollar collapse reach critical mass, they will skyrocket.
Financial institutions around the world will realize that a collapse makes the "hold to maturity" strategy a losing propersition. They will then begin dumping their trillions of toxic US debt at firesale prices, simply to escape the dollar's devaluation.
Bailing out the interest rate swap market will be impossible
Fear of inflation will be the biggest factor driving interest higher and causing stress in the interest rate swap market. So printing money to help banks/companies pay their swap obligations would just feed this fear and make things worse. For more on the negative feedback loop caused by quantitative easing, see *****Treasury Yields Accelerating Upwards*****.
Potential damage from interest rates swaps is INSANE
Consider these two facts:
A) The notional amount of interest-rate derivatives outstanding in the second half of 2008 was $418.7 trillion.
B) Interest rates over 1000% are the norm during hyperinflation
418.7 trillion * 1000% = 4187 trillion annual interest
This means that, when the dollar collapses, those "long the bond" (the floating-rate payers in interest rate swaps) will be the hook for over one quadrillion dollars every quarter. That's over 1,000,000,000,000,000 dollars every three months. Of course, the US financial system and most of corporate America will go under long before it reaches that point.
There will be few survivors of this interest rate swap apocalypse.