Dislocation In The Credit Markets

As we are becoming more optimistic about the sustainable recovery, there is a question being asked: “have we returned to pre-Lehman Brothers collapse norms in the credit markets?” In analyzing the different dislocations, many pundits and policymakers have expressed concerns about the persistence of a negative 30 year swap spread which occurred on 23^rd October 2008 for the first time. As we know, a swap spread is the difference between the fixed leg of the interest rate swap and the treasury of same maturity. In other words, the swap spread reflects the risk premium for money market rates over treasury yields. A simple minded interpretation of this fact would be that US is more likely to default on its debt than the banks transacting in the money market. Now, after a year of negative 30-year swap spreads – which shows little sign of turning positive - some in the market are becoming comfortable with the notion, particularly as the US government continues to fund a surge in borrowing. In my opinion, this analysis and interpretation is simply false. The government which has enabled these banks to stand and walk can’t be more risky than those banks themselves. That leads to what the reason is?

I believe this is a technical dislocation in the market arising due to the limits to the arbitrage arising from inadequate capital, leverage and cautious move from players who invest at the long end of the curve – pension funds, mortgages. The assumption which we have made for long period in Finance that treasury is less risky and any arbitrage arising out of this violation will be wiped out is not at play because of four main reasons. First, the trade requires capital – commissions and collateral for the repurchase agreement and swap. Repurchase agreement allows a borrower to use a financial security as collateral for a cash loan at a fixed rate of interest. Given the losses suffered by financial institutions, there is little risk capital in the marketplace. Second, when the contracts written by Lehman disappeared, some dealers were forced to take significant write downs. This highlighted the under appreciated risk of counterparty exposure in the interest rate derivative markets. Given the counterparty risk concerns present currently an arbitrageur may be reluctant enter a swap. Lastly, driven by the policy need to meet deleveraging standards, firms continue to sell the 30 years treasuries on their balance sheets. This deleveraging has continued to keep the yield high (more supply -> less price -> high yield).

Another important player that is driving the demand for the fixed leg of long term interest rate swap is pension fund. Pension funds need to hedge long-term liabilities (30 years and beyond) by receiving fixed or floating on long-maturity swap rates. Some pension funds concerned about falling rates (which will make the NPV of their liabilities higher) put on new swaps. They could have also achieved their goals by purchasing 30-year bond, but many were trying to preserve their liquidity, focusing instead on swaps. The perseverant demand for the fixed leg of 30 year swap has kept the yield low. In my mind, this is a technical dislocation which should come back to normal in due course of time. I strongly reject the notion that increased borrowing by US has increased the long term risk of default by the US and the risk of default is lower for banks.

However, rejecting this fact by just terming it as a dislocation will be injustice. If prices on such a simple trade are distorted because normal arbitrage forces do not operate, what is the state of the pricing on more complicated assets? What other assets trade with such a long term trade horizon? I see MBS and its derivatives such as CDO and CMO. The spread on GNMA mortgages used to be around 75 basis points (Treasury yield + 75 bp). This spread has gone up to 150 bp in the recent past. A simple explanation would be that investors value the liquidity of treasuries during crises and the yield on all other securities goes up, asking for extra premium. However, as the confidence is restored and the volume of transactions pick up, this should shrink. For financial institutions, this is important because it suggests that the value of financial claims reflecting future mortgage risk is especially low. As the spread tightens, the value of those cash flows will increase. Hence the losses on financial institutions balance sheets are larger than they would otherwise be if prices were at fundamental value.