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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you don’t think a lot of borrowers are locking in rates now, turning their floating rate debt into fixed rate?

Posted by q | Report as abusive

Who was on the other side of those GS trades? Sitting ducks with their wings nailed to wall.

It didn’t work then, and it clearly isn’t working now, either.

That\’s only really true if the swap counterparties were speculators trying to maximize income. If they were trying to reduce risk and provide for more stable earnings (closer to the intended use of derivatives, and actually what Wells Fargo did) then perhaps the hedges worked.

Posted by Dave in NYC | Report as abusive

Who is counterparty to these losses?

It is us, the taxpayers. Goldman Sachs and other investment banks have access to the Fed discount window to borrow at < 1% and are massively arbitraging this privilege with the entire rest of the economy that cannot access the Fed discount window via interest rate swaps.

Posted by Dan | Report as abusive

Well, buying far-dated fixed in 2006-07 obviously wasn’t the best idea in history, but if anything the past year has given a clear sign that sometimes going long fixed can indeed work quite nicely.

Corporate demand for long rate swaps has been absolutely massive in 2009, and anyone buying >5Y fixed during the first half at least will have done very well, as positive mark-to-market is presently trouncing the negative rolling carry.

Likewise, anyone going or staying net short during that time will have been unwise to do so, including Goldman and Wells Fargo.

Posted by S | Report as abusive

A lot of people would rather pay fixed. For instance, my wife didn’t want a floating rate mortgage (I might have been inclined to roll the dice). So we have a fixed rate home mortgage from Citi. But since Citi doesn’t want to receive fixed, they do a swap with Goldman, get floating interest to match their funding source, and pay our fixed rate to the Goldman bondholders. Citi still has the credit risk on our mortgage, but they have alleviated their funding mismatch, Goldman is making money (for now) on a risky bet, and my wife sleeps better.

Posted by y81 | Report as abusive

as long as the Fed keeps the prime rate in the basement, Goldman has a winning plan. sooooo.. as long as Goldman keeps entering these deals, mayyyyybe the Fed (Goldman’s public subsidiary)will keep the rate down.

Posted by Bob M | Report as abusive

If they come out significantly ahead, it isn’t really “hedging”; it’s an explicit bet. The idea of a hedge is to lower risk and volatility; basically, buying insurance. If they have a long risk exposure and buy puts against adverse movement, they shouldn’t make any money on it. They should just not lose. (I’m ignoring hedges that are part of some arbitrage scheme or volatility trade.)

It appears what GS did was just have a naked bet that rates would go down and it paid off. The other side of the trade was someone who wanted a fixed rate, not crazy by any means, but wrong in this instance.

Posted by JackL | Report as abusive

Who is on the other side of the trades ?

There are almost always people who predict a sharp increase in long term interest rates. They are found among blue chip forecasters (TM that’s an aggregator not “blue chip” in the ordinary sense of the word). They are always wrong — that is to say they have were consistently wrong with 0 (zero) exceptions in the data set analysed by Nazaria Solferino and me.
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There may be even more counterparties for Goldman Sachs and Wells Fargo now than is usual.

I hear ordinary people who think they are sophisticated express fear of US hyperinflation. The idea is debt causes inflation and huge deficits imply huge debt (error 1 — they don’t have a sense for how huge the debt was) and therefore huge inflation (they don’t compare pessimistic forecasts of debt to past debt levels which were followed by moderate to miniscule inflation).

I’d guess that a lot of active traders are politically right wing and, therefore, much inclined to predict doom and inclined to call doom hyperinflation.

A verbal quibble. The word “hedge” seems to have lost its original meaning. I’d define a hedge to be a way of insuring risk. With that definition, one can’t make huge profits off a hedge. One can only avoid huge losses.

There is no hint in the post that Goldman Sachs or Wells Fargo insuread any risk which they were bearing — that without the hedge they would have lost money if interest rates fell. I’d call a swap which does not insure against risk a “bet” or a “gamble” not a “hedge.”

Now I don’t really know about the history of usage of “hedge.” My definition might be idiosyncratic. Even if this is so, I think one should have a word for what I call a hedge and should call large positions which do not balance other risk “bets” or “gambles.”

I think the shift of meaning has occured, because financial operators claim that their role is managing risk and not betting against each other. They have strong incentives to make these claims. First they claim that they reduce risk — therefore the way to make the economy safe is to let them do what they want. Second they claim they are making their huge profits without gambling. Therefore their shares should be valuable and shareholders should be willing to pay them huge compensation. Finally, they don’t have to argue that financial markets are inefficient in order to explain what they are doing.

These interests seem to me to have been strong enough to cause them to call gambles “hedges” and even to make skeptics such as yourself accept the shift in meanings.

It is what all banks do, and it would be completely stupid to not do it. It is just very basic banking. And the other side might have been the investors? Maybe they also did not want to receive fixed but swap that (for their one reasons) to floating. The capital market is dynamic, there is not 1 winner and 1 looser, you win some left and you lose some right.

Posted by M | Report as abusive

They are probably just borrowing from the Fed at 0.25 and loaning to Treasury at 3.5. Goldman Sachs is, to use the phrase, ripping our f*****g faces off. It’s what they do.

Posted by Alan Wendt | Report as abusive

I call it money laundering, or better, Legal Money Laundering. It is amazing how people are being made fools and going for it. It is just a matter of one educating oneself to understand that we socialized losses and privatized profits. It is crazy.

Posted by Lino Quagliariello | Report as abusive

FED is DADDY and \”too big to fail\” are the monster kids that want to be helped out…

GSucks is the preferred child( and rep of the govt.), that\’s why they always win…under bush or Obama, they RULE…so is anybody aware of the THEATRical spectacle of the incumbents( all of them should be ousted with real independents, if they exist).

Go GS , you SUCK… but always win….

They are now advertising ‘no money down’ mortgages on the radio again – have we learned nothing?

Posted by Macy Lazarus | Report as abusive

The continuous deregulation since the 1980s has turned the banking and market sectors into gaming tables with the odds tilted toward the house.

Posted by emil hess | Report as abusive