Those lucrative interest-rate hedges

By Felix Salmon
November 5, 2009
Peter Eavis notes something quite astonishing today:

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Peter Eavis notes something quite astonishing today:

The interest rate on [Goldman's] long-term borrowings was a minuscule 0.92% in the third quarter, down from 3.53% in the third quarter of 2008. This $203 billion of debt is Goldman’s largest single funding source, so as its cost plunges, its bottom line benefits…

Goldman has been helped by its use of interest-rate derivatives. When issuing long-term fixed-rate debt, Goldman has for years entered swaps that effectively convert nearly all of that debt to floating-rate. Thus, as interest rates plummeted, so did one of Goldman’s main expenses.

To put these numbers into perspective, a savings of 2.43 percentage points in one quarter amounts to $1.2 billion in saved interest costs on $203 billion. That’s over 40% of its third-quarter earnings.

Even so, Goldman’s hedging gains by converting fixed-rate into floating-rate debt pale in relation to $3.6 billion that Wells Fargo made on much the same trade, hedging its mortgage-servicing rights. Clearly much if not most of the US banking sector made enormous profits in Q3 on interest-rate swaps — profits which are the very definition of unsustainable.

And there’s another question, too: if the likes of Wells Fargo and Goldman Sachs are making billions on these swaps, who’s on the other side of the trade? Who lost billions of dollars by swapping floating into fixed? Call it the Summers trade, after Larry’s disastrous foray into the rates market when he was at Harvard. It didn’t work then, and it clearly isn’t working now, either.

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