Sunday, September 7, 2008

The Critical Role of Interest Rate Swaps in Financial Markets and the Real Economy

Sometime in the fall of 1990, during a lunch conversation with colleagues in what was then Credit Lyonnais, I brought up the idea of writing a book on swaps. The head of HR who had some knowledge of the publishing industry thought I was setting myself up for disappointment. Publishers would not accept a book proposal without an introducing agent, and no agent would take a writer as a client who was not already a published author. Like first jobs and the experience requirement, it was one of those well-known catch-22s, he said.

The same evening – it was on a Thursday – I wrote a 4-page proposal and sent it to Dow Jones Irwin. On Monday they called and offered a contract.

Valuation, Trading and Processing Interest Rate Swaps came out in 1993 under the imprint of Business One Irwin – even then the publishing industry was in turmoil – and, according to the statistics of the legendary McGraw Hill bookstore in New York anyway, became an “industry bestseller”; industry meant technical books in finance. I received a princely sum of $7,500 and many compliments. One mildly critical comment stood above the rest. An academic reviewer wrote: “The chapter on operations is interesting in that it addresses issues not discussed elsewhere but I doubt many people would be interested in how it works”.

I had almost forgotten the book until a friend recently suggested adding it to the list of the books on the blog as a part of the blog’s (very) gradual overhaul.

Interest Rate Swaps has been out of print for a long time. But interest rate swaps are going strong as ever. In fact, though I did not know it then, the spectacular growth of the swap market in the 80s was the driver and the resultant of the rise of speculative capital.

An interest rate swap is simple in concept. Two sides agree to the exchange of interest payments based on a notional amount. (“Notional” because it does not change hands and merely serves as the reference for the calculation of interest amount.) One party pays fixed rate; the other, variable. The variable index is generally the London Interbank Offered Rate, or Libor (pronounced like MY DOOR.) It typically resets every quarter.

Operational issues aside, there is little to add to this description. But nothing exists out of context. Taken into capital markets for which it was designed, the swap structure proved quite revolutionary. It made possible arbitraging corporate credit and interbank lending markets.

The clue to this critical function is in the Libor index, which pertains to the rate banks charge one another. Interest rate swaps enable corporations to borrow cheaper in the variable rate Eurobond market and swap it to a fixed rate.

The quantitative impact of this funding mechanism was phenomenal. Twenty years ago, 80% of the corporate borrowing was through bank financing and 20% through bond market. Today, the ratio is reversed; it is 80% through capital markets and only 20% through bank financing.

Far more important, however, was the qualitative transformation of the markets. You see, if you could use swaps to arbitrage the cheaper inter-bank lending market and the long-term capital market rates, why stop at corporation? Why not bring in municipalities to the game as well, to take advantage of the “efficiencies” of the modern financial markets and collecting no so insignificant fees and bonuses in the process?

That is precisely what transpired. Hence, the rise of auction-rate securities (ARS) and the option tender bonds (OTBs). Under the relentless pressure of speculative capital which aims to shorten the trade horizons, the Libor reset was also reduced to its irreducible overnight frequency. In this way, the overnight swap index (OSI) was born.

Note here that OSI and the Fed Funds rate serve the same exact purpose. They are the rates that banks can borrow overnight from each other (OSI) and the Fed (Fed Funds). Hence, it stands to reason that the difference between them should only be a few basis points (accounting for the higher credit quality of the Fed). That was indeed how it was until summer '07. Since then, the persistently large spread between OSI and FF, over 60 basis points, has provided one of the most compelling signs of continued malaise in the markets.

If you sleep with dogs, you wake up with fleas. If the corporate and municipal bond market are linked to the interbank lending market through swaps, then they are bound to suffer the consequences of any dislocation in the financial markets. Somehow the top central bankers and top economist and top fund managers in Jackson Hole did not seem to grasp this obvious link between the financial markets and what they call – always in quotation marks – the “real economy”.

In Vol. 5 of Speculative Capital, I will show the exact manner in which crises in the financial sector impact the industrial production and service activities. In the mean time, read the following news stories that provide useful background material on auction-rate securities, option tender bonds and the role of interest rate swaps.

The last one is the most entertaining. It deals with the question of the “reliability” of Libor because the index did not behave the way college textbooks and the learned professors had said it should. There were serious and protracted discussion about reforming or replacing the Libor until the discussion slowly faded away, one hopes from embarrassment. There never was a more egregiously foolish shooting of the messenger.

Sense of crisis growing over interbank deals (FT, September 5, '07)

In particular, the cost of borrowing funds in the three-month markets – as illustrated by measures such as sterling Libor or Euribor – is continuing to rise, suggesting a frantic scramble for liquidity among financial groups. This trend is deeply unnerving for policymakers and investors alike, not least because it is occurring even though the European Central Bank and the US Federal Reserve have taken repeated steps in recent weeks to calm down the money markets. Or as UniCredit analysts say: “The interbank lending business has broken down completely … it is a global phenomena and not restricted to just the euro and dollar markets.”

Strategies reborn and lessons learnt – hopefully (FT, October 8, '07)

The TOB programme is a trust that borrows short-term money to buy US municipal bonds. The people setting it up ... buy long-dated US munis with money borrowed at Libor. After paying for a hedge against a rise in Libor, they might net 30 to 50 basis points, but they can leverage that trust up perhaps 12 to 14 times ... The managers have the option of liquidating the trust in case things go against them in some way, or if they decide they want to wind up the business. What they had not counted on was, of course, what happened. In the summer crunch, Libor blew out as banks became suspicious of each other. At the same time, like all non-sovereign bonds, US munis came under suspicion.

Global funding pressures intensify (FT, April 15, '08)

Strains across money markets intensified yesterday and are approaching levels last seen in mid-December ... This was illustrated by higher swaps rates, which compare the difference between overnight lending rates set by central banks and three-month Libor, the rate at which banks lend to each other. In the UK, this spread known as the overnight index swaps (OIS) rate, rose above 100 basis points yesterday and in the US increased to 80.6bp. … These are highly elevated levels and compare with swap rates of around 15bp before the credit crunch emerged last year.

Slowly does it, as calls grow for Libor shake-up (FT, April 22, '08)

The British Bankers’ Association has opened the door to “evolutionary change” in how it calculates London Interbank Offered Rate – Libor – in response to growing criticism about the accuracy of the global benchmark for borrowing costs … The rate has traditionally been considered a key barometer of financial stress and swings in Libor can have big economic implications since many loan and derivatives contracts are based on it ... However, bankers fear the index has become distorted in recent months, particularly in dollar markets, because it is calculated according to bank’s perceived funding costs rather than actual trades.

The emphasis on Libor, OTB and ARS in these stories tends to obscure the central role of interest rate swaps. But that role is ever-present; it is central to the stories. No student of finance can afford to be in the dark about these critical tools of arbitrage. Good finance teachers will see to that.