Friday, 8 June 2012

JPM, Interest Swaps and a US Bond Bubble

It's still not clear how the Whale managed to lose $2 billion (and counting), but most likely that had something to do with interest rate swaps because that's the main way that JPMorgan makes money. Jim Willie who posts under the name of The Jackass has a theory interest rate swaps created speculative demand for U.S. Treasuries and that drove yields down…in other words there is a bubble.
If there is a bubble it will bust eventually; The Jackass says that could be catastrophic because the notional value is so huge.
(Click to enlarge)
Eyeballing the chart, the first thing that stands out is that in three years running-up to the Credit Crunch, the notional value doubled from $200-Trillion to $400-Trillion, then there was a reversal which coincided with the Credit Crunch, then a period of relatively slow growth in notional value, then there was another reversal which coincided with the sovereign debt crisis.
If Jackass is right, you would have thought 2005 to 2008 might have been "worse" in terms of driving down the yield, than 2009 to 2012; the evidence at first-sight seems to suggest the opposite.
What strikes me as odd is that the notional value of the swaps (worldwide) is more than three times the value of all of the debt in the world.
If you look on the Internet you get told that most interest rate swaps are Plain Vanilla, those are when "Party-A" who has a loan with a floating rate, makes an agreement with "Party-B" who has a loan with a fixed rate, so that they swap their obligations to pay interest on their respective loans.
The details of that include some consideration based on the view at the time of the likely direction of LIBOR and say the 10-Year yield. If both had a loan of $100 million, then the notional value of that swap would be $200 million.
So how come the notional value is three times the total loan book? If half the world started with a floating rate, and the other half started with a fixed rate, and they all swapped, the notional value of all those swaps added together would be $150 Trillion or so.
So what's happening?
Well there isn't much information on interest rate swaps. I looked, but all I ever saw was an explanation of how they are supposed to work between two "Parties" who actually have loans to service.
Go to the Bank of International Settlements and you will find their last word on the subject was written in 1993.
Equally, there is absolutely no information on how many loans out of the total outstanding in the whole world got swapped, although it would surprise me if it was more than 10%.
That suggests the notional value of all the loans that got swapped is no more than $15 trillion, and that the vast majority of interest rate swaps (perhaps 95%) are synthetic.
In other words, 95% of the time, Party-A contracts with Party-B to pay a cash flow of say 3% of $100 million for ten years into the future, and Party-B agrees to pay Party-A the cash flow of LIBOR plus whatever, based on a loan of equal term of $100 million for the same period.
The notional value of that swap is $200 million, but the only obligation either party has to anyone is to their counterparty in the swap…neither actually has a loan to service.
So What?
Well Momma, this is the thing. Babies grow up to be boys, and boys will be boys, and bankers, well they just grow up to be cowboys.
The $450 Trillion synthetic "book" could just as easily be held by a casino with the obligation to pay by the gamblers dictated by the results of a football game.
Except the results of a football game are not (normally) influenced by the way the betting goes. In this case, thanks to the way bonds are valued, there is plenty of scope for the betting to influence the result, at least short-term…that's what bubbles are all about.
To give an example of how the way the betting goes; influences the result. Remember in the not-to distant past, all the cowboys bet that house prices in U.S.A. would go up, forever and forever.
And well, because of that house prices went up for quite a long while because there was an unnaturally high amount of money available to buy houses. And the money was available because the cowboys thought that result was as close to a sure-thing as what's going to happen when you drop a rattler into the same cage as a kangaroo rat.
Except that was a bubble, half of the cowboys doubled their money, half of them lost everything, net-net no one made any money…except the casino. Fortunately, for the cowboys who lost, the government and the central banks stepped in to help them back on their feet so they could do it all over again…Happy Ending!!
So did interest rate swaps change the result for U.S. Treasuries?
The problem with any bubble is that it's hard to get a grip on what the price "ought" to be. During a bubble, everyone has an explanation for the "bit of froth", of which the commonest, and the most asinine, is the idea of mark-to-market. As in markets are efficient and true-value is simply the price you can sell something for, to someone dumber than you. Which works great, until you find out you are dumbest person in the room.
In a previous set of articles I have proposed that regardless of how Larry Summers "solved" the Gibson Paradox in his youth…and later went on to lose Harvard University a bundle doing the cowboy thing with interest rate swaps, which suggests he might not have actually solved the paradox, what determines the "right" price of say the yield on the 10-Year is trailing nominal GDP in U.S.A.
You can argue why that could be right or wrong until you are blue in the face. But that logic predicted, in February 2010, that the 10-Year yield was headed down towards 3%.
That was correct but it was pretty much a minority point of view at the time.
OK that's just one prediction based on a theory, notwithstanding, Milton Friedman once said…"The question whether a theory is realistic "enough" can be settled only by seeing whether it yields predictions that are good enough for the purpose in hand or that are better than predictions from alternative theories."
Not many economists or financial cowboys agree with that idea, many are so in love with their theories they keep banging away with them regardless of how many times their predictions turn out to be wrong.
So that theory made a correct prediction once. Other theories like those of Lawrence Summers, Bill Gross, Nassim Taleb, and probably Nouriel Roubini although his predictions are so vague they could mean anything…their theories, conclusively, produced the wrong answer. That doesn't mean my theory is right, but the chances of it being wrong are less than 10%, whereas the chances of the other theories being wrong, based on the evidence so far, is 90% to 100%.
The theory produces a base-line for what the yield on the 10-Year "ought" to be, that base-line is what International Valuation Standards calls "Other Than Market Value", and some people call "Fair Value".
So if that "valuation" says yields should be 3% today, but they are 1.5% then the bonds are selling at twice the price they "ought" to sell at so the "mispricing" by the market is 100% and that's a bubble.
Here's a plot of that estimate of the mispricing of 10-Year Treasuries, against the growth year on year of the notional value of interest rate swaps worldwide. The point is that [IF] it looks like there is a correlation between that estimate of mispricing (and the theory is right), [THEN] it's possible the largely synthetic market for interest rate swaps is influencing the yield…i.e. perhaps it's causing bubbles:
The way I read that chart:
1: A period of increased notional value of interest rate swaps (A, B, C) appears to coincide with an increase of mispricing (10-year yields go down further than they "ought" to be, so the percentage mispricing, (the blue line on the chart) goes up).
2: When the rate of increase of the notional value goes down suddenly, what happens after six months is that the bubbles appear to pop. That's shown by the little red-arrows and the black dotted line.
Predictions:
If that theory is right, i.e. that interest rate swaps do drive disequilibrium in bond markets, then:
1: There is a pop in the bubble of U.S. Treasuries on the way
2: In about a year's time the yield on the 10-Year will be knocking on the door of 4.5%.
Discussion
It is legitimate to ask, what's the point of interest rate swaps outside of making huge amounts of money for the bankers who bet correctly, and wiping out the bankers who made the wrong bet, who will probably end up banging on the door of the Federal Reserve saying they are too-big-to fail, and if the Fed doesn't bail them then the synthetic market they created will blow up, and then the whole of the world's financial system will blow up.
What I don't understand is the difference between that process, and terrorism. Basically terrorists threaten to blow things up unless they get their way, or at least get given large sums of money, that's pretty much what the cowboys do….what's the difference? Certainly, the economic damage that the cowboys inflicted on U.S.A. and Europe, is hugely more than anything the long-bearded outlaw, who got the tap-tap in the middle of the night, even dreamed of.
Insofar as the story about the economic value-add of "helping" borrowers who are stuck with a floating rate, "reduce their risk", that's just a crock of horse manure. The reality is that if you have less than perfect credit you can't borrow at a fixed rate…unless of course you are an unemployed drug-addict in Detroit in 2007. But otherwise, you have to borrow at LIBOR plus whatever.
But, and this is the catch, the bank tells you that you have to swap a portion of the loan they give you to "fixed"….and guess what…as chance would have it they got just the thing for you…it must be your lucky day!!
That's what typically happens when you are a utility company, a municipality, or a commercial building. Your cash flows are relatively predictable, but LIBOR isn't.
So that means for the geeks in the bank, the Debt Service Coverage Ratio (DSCR) going forwards, is uncertain…so they force you to swap, to offset their risk.
That's a bit like how the demand for "investment grade" debt was stoked up to a crescendo which was used to finance the housing bubble. Pension and insurance companies were obligated by regulators to hold a certain (high) proportion of their assets as Investment Grade, which is what drove the huge demand for "investment grade" assets from 2000 to 2007….which turned out to be toxic….remember that?
People say Greenspan caused the credit crunch. He didn't, the money for the bubble came via securitization and the driver was regulation…too much regulation of what pension funds and insurance companies did and too little regulation of the crooks who were manufacturing toxic securitized debt to shove down their throats.
With the government and the regulators standing by-in-attendance to make sure everyone took their medicine. "Good for the economy...you see?!!"
And from there the Alice in Wonderland tale mutated to "creating" the dubious economic value-add of synthetic collateralized debt obligations and credit default swaps which were sprinkled into the witch's brew like so much LSD. And guess what? They blew up too….remember that?
Funny thing how when idiot politicians and dirty bankers get together with a big idea to mess with markets, things tend to blow up?
The people who made money out of the huge drop in LIBOR engineered by the Fed and the BOE were the banks who had previously swapped a fixed rate (synthetic or not), with some poor jerk who had been paying LIBOR. That's why (A) QE didn't cause (much) inflation (B) the banks that were heavily into interest rate swaps (like JP Morgan) made a fortune out of the fall-out from the credit crunch (C) the "easing" by the Fed did not translate into increased nominal GDP.
What remains to be seen is how JPMorgan (JPM) and the other cowboys make out when the tables turn. Could be seeing a lot of busted cowboys (and whales) walking the streets of Laredo on the near future, begging for handouts.
by Andrew Butter

2 comments:

  1. I can't help but wonder how complex the business and accounting software of an entire country can be. I mean, that's a lot of businesses and money to keep track off.

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  2. Considering the amount of money involved in transactions like these, all us citizens can hope for is that our leaders have good global wealth management. With financial crises hitting many countries these days, it's all too easy for any of the other states to dig themselves into an economic hole.

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