READ ALL THE

"SULTANS OF SWAP"

ACT I

Sultans of Swap: Smoking Guns!

ACT II

Sultans of Swap: The Sting!

ACT III

Sultans of Swap: The Get Away!

ALSO

SULTANS OF SWAP: Explaining $605 Trillion in Derivatives!

SULTANS OF SWAP: Fearing the Gearing!

FOR UPCOMING SHOW TIMES SEE: COMMENTARY

Saint-Etienne Swaps Explode as Financial Weapons Ambush Europe

1- Saint-Etienne in central France,

2- Pforzheim in western Germany and

3- Apulia, an Italian regional government on the Adriatic

Harvard University in Cambridge, Massachusetts,

agreed last year to pay more than $900 million to terminate swaps that assumed interest rates would rise.

Under the interest-rate swap deals popular with European municipalities, a bank would agree to cover a locality’s fixed debt payment and the government or agency would pay a variable rate gambling its costs would be lower -- and taking on the risk that they could be many times higher.

Use of swaps in Europe soared in the late 1990s and early 2000s because banks pitched them as the easiest way to reduce costs on fixed-rate loans, according to Patrice Chatard, general manager of Finance Active, which helps more than 1,000 localities across Western Europe manage their debt.

City and regional governments in Europe mainly get their financing from banks, while in the U.S. they primarily raise funds by selling bonds to investors. Municipalities and other local authorities in the European Union’s 27 member states had a combined debt of 1.21 trillion euros in 2008, according to Eurostat, the EU’s statistics agency.

Government officials used up-front cash payments from guaranteed rates at the beginning of swap contracts to artificially lower their short-term financing costs and live beyond their means, said Emmanuel Fruchard, who is a city council member in Saint-Germain-en-Laye, near Paris.  “These municipal swaps are the same thing as Greece,” said Fruchard, a former banker at Credit Lyonnais, now a unit of Credit Agricole SA, who designed swaps in the early 1990s. “It’s all trying to dress up your accounts.”
 

Germany, Italy, Poland and Belgium also used derivatives to manage fiscal deficits, Walter Radermacher, the head of Eurostat told EU lawmakers in Brussels yesterday without being specific.

Municipalities are having to rewrite their budgets. Saint- Etienne raised taxes twice, slashed by three-fourths a plan to renovate a museum commemorating the region’s extinct coal mining industry and sparked the cancellation of a tram line. Pforzheim, on the edge of the Black Forest in Germany, is scrimping on roads, schools and building renovations.

Known as Gold City for its historic jewelry and watch- making industry, Pforzheim was ordered by the Baden-Wuerttemberg regional government office in Karlsruhe to cut its budget by 240 million euros, or about 12 percent annually, over the next four years because of a 55 million-euro loss on derivatives and a projected 50 million-euro annual shortfall from a decline in tax revenue and rising social costs.

The town followed the advice of Deutsche Bank in taking out bets on interest rates in 2004 and 2005, according to Susanne Weishaar, Pforzheim’s budget director until March.
 

More than 1,000 municipalities in France had 11 billion euros in “risky” contracts at the end of 2009, according to Paris-based Finance Active. In Italy, about 467 public borrowers faced losses of 2.5 billion euros on derivatives as of the end of September, according to the Bank of Italy.

In Germany, Deutsche Bank sold contracts based on the difference between long- and short-term rates to about 50 municipal governments and utilities. Local authorities also bought swaps from regional banks and Commerzbank AG. No national consolidated figures exist, according to Roland Simon of Simon & Partner, a law firm in Duesseldorf.

For cities like Saint-Etienne, the risks from buying swaps were out of proportion to the potential savings.
 

Lots of confused chatter in the bond community as to why the negative swap spread story (anywhere between 7Y and 30Y) is being largely ignored by the media. After all, the associated market, which according to the BIS was roughly $154 TRillion in June 30 makes the Greek bond debacle and various sovereign CDS discussions in the media pale in comparison. As several bond traders pointed out, the likelihood of negative spreads having been modelled out by the TBTFs is very low, if any, meaning that unhedged bank IR-swap exposure is suffering massively, and is likely to surpass all record past prop desk losses. In fact, rumors abound that a few of the desks having placed leveraged bets on spread divergence over the past months and years are currently in critical condition, yet nobody is discussing this for fear of another round of bank run concerns among the TBTF banks. What is odd, is that the Primary Credit borrowings are now at almost financial crisis lows of just under $9 billion, leading many to speculate that banks now satisfy all of their short-term funding needs via the fungibility of excess reserves (and indicating once again that the Fed's discount rate hike was the most irrelevant action in a history of irrelevant actions). And just in case there is still confusion as to what negative swap spreads mean, here is a useful primer.

From Morgan Stanley:

The big news is that 10y swap spreads (Swap Spread = Libor Rate - UST Yield; e.g. 10yr swap spread = 10yr Libor Rate - UST 10yr yield. This spread has always been positive, today it is negative implying that UST 10y yields have risen above 10y Libor rates) have fallen below zero (Exhibit 1). But the bigger questions are how do we define value in spreads and how much more inverted can 10y spreads go? At the height of the crisis in 4Q08, 30y swap spreads got to -41bps and have remained inverted ever since. The inversion of 30y spreads had more to do with technical, exotic and hedge-related factors. But those elements are missing from the inversion of 10y spreads. That's what makes it interesting. Today we view the inversion in 10y swap spreads as a harbinger of the massive supply of UST debt that will ultimately drive yields higher.

What drives swap spreads?

Back in the late 1980's and early 1990's, swaps were a ground-breaking innovation. It was a “magic formula” to turn long-term liabilities into short-term liabilities. ABC Company would issue (that is, pay an interest rate) on, say, 10yr debt in the market, then receive a 10yr fixed interest rate in the Libor market while simultaneously paying a 3-month floating Libor rate (Exhibit 2). And voila, ABC Company 'swapped' a long-term fixed liability for a cheaper and easier to manage short-term liability. Magic! But things were simpler in days of yore. Swaps were a less volatile vehicle used by corporations to manage cash flows on their debt. They used swaps because they could customize the end dates of their fixed cash flows, rather than relying on US Treasuries with their pesky issuance cycles and inherent technicalities. For example, 10y spreads from 1992–1997 trade in a range from 28bps to 41bps, pretty narrow. But this simplicity allowed us to understand what drove swap spreads. These factors were primarily:

1. The spread between Libor and repo rates
2. The slope of the yield curve
3. The US deficit and UST supply

The first point argued that Libor rates should be higher than UST rates because there was a 'repo-specialness' premium between UST’s and Libor. The second point refers to corporate issuance: if the curve steepens, then corporations are more likely to swap their long-term liabilities at higher rate levels into short-term liabilities at lower rate levels. The last point refers to the relative level of UST issuance. If the US economy slows and goes into a deficit, then the US will issue more Treasuries to fund itself, therefore narrowing swap spreads (Exhibit 3). Currently, we have a high 9.9% deficit to GDP ratio and correspondingly, a $2.4Tr gross issuance of UST’s in 2010.

What has changed?

Later in the 1990s and over the last decade, the swaps market took on increased importance not just as a hedging vehicle but also as a speculative vehicle. What drove swaps over the past 10 years has been hedging the interest rate sensitivity in mortgages. But today, a case can be made that mortgages are less interest rate sensitive than in the past (i.e., less negatively convex). The reason is that households may be less able to refinance their mortgages for a given change in interest rates, because refinancing is more related to FICO scores, credit availability, loan-to-value, incomes, etc. We believe swap spreads will narrow and remain inverted as interest rates have stayed low and stable, volatility has fallen, spread products have been narrowing, and there is little hedge-related need to pay fixed in swap. Add to that the old-time reasons, which are becoming more popular drivers of swap spreads today, of reduced specialness premiums, tighter repo-Libor spreads, steeper yield curves and monstrous US Treasury supply. All of which become the contributors to 10y swap spreads moving negative. Oddly, the tight level of swap spreads is a look back into the future. But the inversion of spreads is the new twist.

Morgan Stanley's conclusion is that, independently of our concerns, US Treasury rates are about to spike. To be sure, MS has been pushing for high rates and major curve steepending for a while: recall it is their call that the 10 Year will hit 5.5% this year.

The issuance of UST debt is dwarfing Libor-related issuance. For example, we expect UST net issuance to be $1.7Tr and net issuance of MBS to be zero. Thus, the relative issuance of UST’s vs. Libor-based products mainly accounts for the inversion in swap spreads. This is a first sign of stress leading to higher UST yields and is not to be missed.

And back to our question: is there currently a massive P&L hit to some or all of the Big 5 US banks as a result of this very much unexpected inversion? While surely the full $154 trillion or so amount is not applicable to the 7Y+ inversion, the OCC as of its most recent report does indicate that there is $27 Trillion in Interest Rate swaps outsanding with a maturity greater than 5 years.

And when looking at IR holdings by bank, it would seem that JPM, Goldman, Bofa, and Citi are most impacted. While JPM, GS, BofA, Citi and Wells have about $131 billion in IR swaps among them, more relevantly, JPM, Goldman and BofA have $9, $7 and $5 trillion in >5 year IR swaps. This is very troubling.

Maybe some of those fantastic financial analysts who were telling the general public to buy Lehman a few days before its bankruptcy, and are now saying financial companies will quadruple over the next few years, can do something useful for a change and ask the executive teams of the above mentioned banks 1) how big their exposure to negative swap spreads is and 2) what the negative P&L impact as a result of this unprecedented spread inversion is?

COMMENTS

It is not as if no one was able to see this coming. See The Next Step in the Bank Implosion Cycle??? - http://boombustblog.com/200910271188/The-Next-Step-in-the-Bank-Implosion-Cycle.html. I warned about FX and IR swap exposure last year. Goldman is trading at an extreme premium from a risk adjusted book value perspective. 

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As a result of a surge in interest rate and Forex contracts, dependency on revenues from these products has increased substantially and has in turn been a source of considerable volatility to total revenues. As of 2Q-09 combined trading revenues (cash and off balance sheet exposure) from Interest rate and Forex for JP Morgan stood at $2.4 trillion, or 9.5% of the total revenues while the same for GS and BAC (subscribers, see  BAC Swap exposure_011009 2009-10-15 01:02:21 279.76 Kb) stood at $(196) million and $433 million, respectively. As can be seen, Goldman's trading teams are not nearly as infallible as urban myth makes them out to be.

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Then there is always my favorite graph:

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 Cembalest March 30

Another toxic asset -- interest-rate swaps -- is coming home to roost  Fort Worth Star

According to Moody's, Texas accounts for 17 percent of all swaps in state and local government, and the investments are preventing a wave of refinancing at today's rock-bottom interest rates.
Starting in the early 2000s, they became popular with cities, school districts and state agencies, in part because investment firms marketed them so effectively. For several years, they worked great, saving millions in interest for taxpayers. But that changed after the credit markets imploded and Lehman Bros. failed, triggering downgrades on municipal bond insurers, counterparty banks and borrowers.

New York state, for instance, reported losing $23 million in interest and $79 million in terminations last year because of swaps. That was offset by $143 million in savings in previous years, but today's hits are coming when local governments face declining budgets.

The Service Employees International Union, whose members include government workers, says strapped cities nationwide are paying $1.25 billion in charges from the swaps.

SEC Enforcer Probes ‘Egregious Conduct’ as Muni Scrutiny Widens BL

States and localities have also turned to unregulated derivatives to lower borrowing costs and generate cash to close budget deficits. Many of the contracts had to be unwound at a cost of billions of dollars because the floating-rate debt they were hedging was affected when bond insurers lost their top credit ratings.

“You combine difficult financial circumstances with some of these complex issues of valuations or assessing liabilities, and that contributes to our conclusion that this is an area worthy of specialized focus,” Robert Khuzami, the SEC’s director of enforcement, said in a telephone interview.

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The US 10-year swap rate traded below the 10-year Treasury yield for the first time on Tuesday, as hedging activity from corporate bond deals helped break a fundamental relationship between derivatives and bonds

The 10-year swap rate fell more than 2 basis points below the yield on government paper, after closing 3bps above the Treasury note on Monday. In late afternoon trade, the 10-year swap rate was 3.655 per cent, while the 10-year note yielded 3.68 per cent.

Swap rates and Treasury yields have been converging in recent weeks, driven by high government bond supply, and increased demand by investors using swaps for meeting long-dated liabilities rather than committing capital to buying bonds.

Large issuance of corporate debt this week, which is swapped from fixed coupons to floating rates, has also narrowed the difference between swap rates and Treasury yields.

“Issuance is huge and a lot of corporate bond deals are being swapped and no one is fighting the other side of that,” said George Goncalves, head of fixed income strategy at Nomura.

Analysts say a number of structured derivative trades will cease paying a coupon should swap rates fall below those of Treasury yields; this may spark a bout of hedging, which intensifies the negative relationship between swaps and Treasuries.

In the UK, the current 10-year swap at 3.80 per cent sits below the 10-year Gilt yield of 3.91 per cent.

Historically, yields on government bonds have traded at a discount to the derivative as swaps are money market instruments whereas Treasuries reflect triple A sovereign risk. Funding a swap trade over time is more expensive than Treasuries, but constraints on balance sheets make it difficult for traders to implement such trades.

Goldman’s Greek Swap Spurs ECB to Seek New EU Deficit Rules  Business Week / Bloomberg

The two-page document is titled “The Use of Derivative Transactions in Deficit Financing and Government Debt Management, The Greek Case.”

On 30 July 1998, Alan Greenspan, then Chairman of the Federal Reserve argued that: "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary." In October 2008, the now former Chairman grudgingly acknowledged that he was "partially" wrong to oppose regulation of credit default swaps (CDS). "Credit default swaps, I think, have serious problems associated with them," he admitted to a Congressional hearing. His current views on wider derivative regulation remain unknown though his recent speeches don’t favor greater regulatory oversight generally. Politicians and regulators globally are currently busy drafting laws to regulate derivatives. A common theme underlying the activity is an absence of knowledge of the true operation of the industry and the matters that need to be addressed. As Goethe observed: "There is nothing more frightening than ignorance in action."

GRAND SPECULATION
Stripped of quantitative hyperbole, derivatives enable traders to take the risk of the asset without the need to own and fund it. For example, the purchase of $10 million of shares requires commitment of cash. Instead, the trader can instead enter a total return swap (TRS) where he receives the return on the share (dividends and increases in price) in return for paying the cost of holding the shares (decreases in price and the funding cost of the dealer). The TRS requires no funding other than any collateral required by the dealer; this is substantially less than the $10 million required to buy the shares. The trader acquires the same exposure as buying the shares but increases its return and risk through leverage.

Derivative volumes are inconsistent with pure risk transfer. In the CDS market, volumes were in excess of four times outstanding underlying bonds and loans. In the currency and interest rates, the multiples are higher.

Investors searching for return drive speculation

Facing increased pressure on earnings, corporations have increasingly "financialized,” resorting to speculative derivative trading to meet profit expectations.

Recent experience suggests that in stressful conditions speculators are users rather than providers of scarce liquidity. Speculative activity amplifies rather than reduces volatility and systemic risks. Perversely, this may impede capital formation and also increase the cost of capital for companies. Current regulatory proposals do not attempt to deal with speculative activity in the derivatives markets.
 

SENTINEL UPDATE: The Maturity Wall

An Italian derivatives headache for JP, UBS, Deutsche and Depfa   FT Alphaville

An Italian judge ordered on Wednesday four international banks to stand trial on charges four international banks to stand trial on charges stemming from a 2005 derivatives swap for a 1.68 billion euros bond by the city of Milan, legal sources said.

Buyer's remorse has hit some cities and states that did deals with Wall Street in different times. Hundreds of U.S. municipalities are losing money on interest-rate bets they made during the bull market in hopes of protecting themselves from higher rates. The deals backfired when rates fell, shriveling the sums paid to municipalities. Now some are criticizing Wall Street and trying to exit the contracts.

The Los Angeles city council approved a measure this month instructing city officials to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city's wastewater system, currently is costing the city about $20 million a year. The banks declined to say how they would respond to a request to renegotiate.

In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap with J.P Morgan Chase & Co., according to state auditor general Jack Wagner. J.P. Morgan declined to comment.

State lawmakers have proposed restrictions on municipalities' ability to use swaps. "It's gambling with the public's money," Mr. Wagner said. "Elected officials are simply no match for the investment banker that's selling the deal."

The Service Employees International Union said Chicago, Denver, Kansas City, Mo., Philadelphia, Massachusetts, New Jersey, New York and Oregon all are in the hole on swaps agreements they made with financial firms. The required payments range from a few million dollars to more than $100 million a year, the union said.

Such deals are deepening the misery faced by state and local governments throughout the U.S., already facing their worst financial squeeze in decades because of shrinking tax revenue and stubbornly high pensions and other costs.

Government agencies that saw the transactions as a cushion against fiscal surprises now are being squeezed by the arrangements. The supply of municipal derivatives swelled to more than $500 billion before falling in the past two years, estimates Matt Fabian, managing director at research firm Municipal Market Advisors. Moody's Investors Service says the surge was fueled by Wall Street marketing efforts, demand from state and local governments and "relatively permissive" statutes on the use of swaps in Pennsylvania and Tennessee, both of which are taking steps to tighten rules.

Many of the deals generated higher fees for securities firms than traditional fixed-rate debt. Government officials, for their part, entered the deals in hopes of reducing borrowing costs.

The swaps were introduced in many cases along with floating-rate debt that municipalities issued because it was cheaper than traditional fixed-rate debt. Lower interest rates have served them well on this; their borrowing got cheaper

But municipalities also added swaps to the mix, promising to pay a fixed rate to banks, often 3% or more, while receiving payments from banks that vary with interest rates. On the swaps, the municipalities generally have been losers, as the interest that banks have to pay them have often fallen below 0.5%.

Government budgets are stretched thin, prompting officials to look for dollars wherever they can. The clashes over the swaps come amid growing scrutiny of the municipal-bond market, where the U.S. government is investigating whether there was bid rigging in certain cases.

Wall Street firms say no one was complaining when the deals were helping municipalities save. Defenders of swaps say they still can help cities if paired with the right borrowing strategy.

Some securities-industry officials say they are open to renegotiating with municipalities so long as doing do doesn't cause a tidal wave of demands.

"If they can't come to an agreement on how to modify, the contract should stand," said Michael Decker, a managing director at the Securities Industry and Financial Markets Association, a trade group.

Escaping isn't cheap or easy. Under a transaction between Oakland, Calif., and a Goldman Sachs Group-backed venture, Goldman paid the city $15 million in 1997 and $6 million in 2003, according to Oakland financial reports. But now, the city stands to lose about $5 million this year.

That money "is coming out of taxpayers' pockets and could be used for other things," said Rebecca Kaplan, a city council member. She wants the city to renegotiate. But the city faces a $19 million termination payment. Oakland officials didn't respond to requests for comment.

Some deals have led to court. Last August, a unit of bond insurer Ambac Financial Group sued the Bay Area Toll Authority for payments it said it was owed under various swap agreements. The authority paid Ambac $104.6 million to terminate the swaps after the insurer's credit ratings were downgraded and bonds associated with the swaps were retired. Ambac claims it is owed $156.6 million under the agreements.

The toll authority, which is fighting the claim, said it made the payment, and Ambac sued for the other part of what it says it is owed. An Ambac lawyer couldn't be reached for comment.

Next month, Richmond, Calif., is expected to restructure a $65 million agreement with Royal Bank of Canada that could cost the struggling city an estimated $3.5 million a year, based on current interest rates. Under the revised deal, Richmond would make smaller, more regular payments to the bank over time.

In November, RBC and city officials rejiggered a separate transaction that would have cost Richmond about $2.5 million. An RBC spokesman said bank officials are working with the city to "restructure the underlying bonds in a way that best serves the city's interests and those of its residents."

The "goal of the original transaction was to lower borrowing costs for the city," the bank spokesman said, adding that the bonds didn't perform s anticipated because of downgrades at bond insurers that backed them.

Richmond's vice mayor, Jeff Ritterman, said he still is reviewing next month's proposed restructuring. Financial woes have forced Richmond to cut its budget and lay off employees.

The relationship between bonds and derivatives in the UK and the US is being distorted by record government debt issuance, in a clear sign that massive fiscal borrowing is overwhelming the markets.

In normal market conditions, yields on government bonds, such as US Treasuries, UK gilts and German Bunds, trade at a discount to swap rates. This is because swap rates are based on a funding rate that is linked to the interbank lending market. This rate is higher than the repo rate used for financing government bonds. Swaps are money market instruments whereas Treasuries reflect triple A sovereign risk.

However, in the UK 10-year swap rates started trading below equivalent government bond yields in December while recently in the US they traded at a record low of just 2 basis points above government rates.

In the UK, the negative relationship persists, with 10-year government paper at 4.04 per cent and the swap rate at 3.89 per cent. Swap rates have never fallen below bond yields in the US.

"It's a big story and it has a lot to do with the huge amount of supply that must be digested by the market," says Alex Li, strategist at Credit Suisse.

Analysts say the negative spread between swaps and gilts reflects a combination of rising government bond yields, due to worries over supply, and falling swap rates as pension funds, in particular, look to use swaps for meeting long dated liabilities rather than commit capital to buying bonds.

The UK situation also suggests that the default risk for private institutions, such as the pension funds and banks that use swaps, is lower than the UK sovereign risk, despite the state being triple A rated and having the power to raise taxes.

"It is a strong sign of worries about supply as government bond yields are in theory still considered risk free, and therefore should trade below swap rates, which are a reflection of the private markets," says Steven Major, head of global fixed income at HSBC.

"I think this narrowing is due to misplaced concerns about sovereign credit quality in the UK," he adds. However, concerns about sovereign risk look unlikely to go away, with Moody's warning yesterday that the US and UK were moving closer to losing their triple A ratings.

The theory that swap rates should not trade below Treasury yields because they present arbitrage opportunities that can be exploited via the different rates for funding Treasury and money market instruments has been in doubt since the 2008 financial crisis.

Executing such a trade depends on committing capital for an extended period, something that has become very difficult in the current era of balance sheet constraints.

With the demise of Lehman Brothers, US 30-year swap rates fell below those of 30-year government yields and have remained that way. This shows the difficulty of financing long term balance sheet trades in an uncertain financial world. "Some people have been calling for the 10-year spread to get to zero, others are fighting it, but if the 30-year spread can turn negative, the 10-year can follow," says Gerald Lucas, senior investment advisor at Deutsche Bank.

In the UK, the economic outlook has been complicated by worries over the Bank of England's decision to put quantitative easing on hold, says Mr Major. Concerns over a hung parliament (the UK general election is expected on May 6) have also pushed gilt yields higher.

Another factor in the UK is that pension fund demand has pushed swaps into negative spread territory, as rather than commit cash to buying bonds, funds have chosen swaps to lock in long term fixed rates, a synthetic way of buying a bond and receiving a coupon payment.

In the US, there are indications that much of the US swap market has been caught out by the lack of a sharp upward move in rates. Traders say that many structured products based on swaps have been set up in recent months, designed to profit from a sharp rise in market rates, which to date have not materialised.

At the start of March, US swap rates were 8.5 basis points above the 10-year Treasury yield. The 10-year swap was trading yesterday at 3.76 per cent, against a 10-year government yield of 3.72 per cent.

"Positioning matters and we could easily see swap rates converge on Treasury yields based on the fact that people are heavily biased towards rising rates once the Fed ends it mortgage buying at the end of the month," says George Goncalves, head of US rates strategy at Nomura Securities.

"If we don't see a sharp rise in rates, the swap market will move much faster than Treasuries as those positions are reversed," he adds. "I think it's too early to suggest this is a credit issue for the US," says John Brady, senior vice-president at MF Global. "It's highly probable that we see a negative [US] swap spread and it's a clear example of too much cash chasing too little yield."

Also pressuring the US and UK markets is the expectation of further corporate issuance. Much of this debt is seen coming from financials, as they swap the fixed rates of bond payments into floating rate exposure. That type of swapping activity compresses swap spreads and there are indications that some dealers have been getting ahead of a swapping wave.

Mr Lucas says: "It reflects a combination of Treasury supply, the attractiveness of using swaps over cash bonds by some long-term investors and expectations of strong corporate debt issuance in March."