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

By Felix Salmon
June 2, 2009

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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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.

So you’re saying that with swaps, when a firm declares bankruptcy its swaps assets are marked down to nothing. Don’t it’s swap liabilities get frozen at the date of bankruptcy and become part of the unsecured obligations. How can there be asymmetry on this?

Why don’t the banks just end up owing the money to GM in bankruptcy? If the banks posted collateral to GM for future obligations (which is I believe the norm), does GM get to keep the collateral — or is it supposed to pay it back?

I can understand freezing the value of the swaps at the date of bankruptcy — and allowing the banks to settle at that value (rather than carry on with a contract that the other side is unlikely to honor), but I don’t see how it can be possible that bankruptcy releases a firms’ debtors from their obligations.

It’s just really hard to make sense out of this.

Posted by Confused | Report as abusive

GM has been forced to deal via GMAC as a counterparty for awhile and the positions are too small to impact the market anyway, except possibly in the xccy swap market which is very thin.

GM wouldn’t reject swaps that are in the money to it. This could still be having an effect if there are some swaps that are not in the money to GM, but to the extent that most of the swaps are in the money, they wouldn’t be “torn up”. On the other hand, the fixed coupon against which GM was hedging has been torn up; the estate would want to cash them out. So while you wouldn’t get the banks suddenly generating selling pressure, the bankrupt GM estate would be generating selling pressure.

(In fact, if you’re hedging a swap against a really risky credit, you’ve already partly backed it out. You wouldn’t get as big an effect all of a sudden when they were being torn up, in a completely expected manner, as if the banks felt they should continue hedging them fully (because they were in the money to GM) and now, only after filing, had started trying to cash them out.)

CDS are also zero-sum, so I guess that’s why nobody pays attention to them? Seriously who is this guy Felix Salmon and why does anyone care what he says?

Posted by Pedant | Report as abusive

As of yesterday;
10Y UST yield: 3,640%.
10Y USD SWAP yield: 3,972%.
That is ok.
But, while
30Y UST yield: 4,490%
30Y SWAP yield: 4,338%, i.e. swap yield is lower than the yield of UST.
This is bizarre, because it implicates as if UST carry more credit risk than swaps. It’s probably a matter of the convexity connected to the price and the yield of the bonds.

When a company goes bankrupt, the swap doesn\’t disappear. If bankrupt companies owes you money, then you \”unwind\” it by yourself, essentially freezing the NPV as of filing date and have a trade claim in the bankruptcy process. If you owe them money, they still count that as an asset, I am not sure how it gets unwound though.

Posted by taxpayer | Report as abusive

I am certain that the GM bankruptcy is actually having almost no impact on the swaps market this week. For starters, their finance arm, GMAC, was the more active market participant, and they are still a going concern. But more importantly, banks will tend to anticipate these events and gradually diminish the magnitude of their offsetting hedges as a counterparty default becomes more likely. GM has been a slow burn for a couple of years now, so banks have had ample opportunity to prepare to close out their swaps. In contrast, when you have a sudden default (like Lehman, or even Enron) the banks end up all moving at the same time to replace (or unhedge) these positions.

Posted by reuben | Report as abusive

Just a comment,
With all the stimulus rhetoric everywhere, has anyone else tried to actually get money from a bank or financial institution? I guess you have to either be a bank or the auto industry because it’s next to impossible. Promises of low interest loans are absolutely no good, because due to the present financial state of most people, they don’t qualify! So much for helping the little guy!

Posted by greg coleman | Report as abusive