Negative swap spreads

June 2, 2009 in Finance

Felix Salmon writes about the negative swap spread - a fascinating turn of events. Or at least, it was when the swap spread went negative almost a year ago.

The swap spread is the extra amount that an interest rate swap yields over a similar Treasury bond. Typically, a swap yields a few basis points more to compensate investors for the extra risk that comes from dealing with a bank instead of with the US government. Shortly after the Lehman default, however, a funny thing happened: the 30 year swap spread became negative. Effectively, it was cheaper to deal with a bank than with the government. Since then, the spread has wavered between 0 and -40 basis points.

What inspired Felix's post was the large moves in the swap spread over the last few days. He speculates that it is on account of GM-related hedging (and counter-hedging) activity.  I'm not convinced that is the case. Though the swap spread moved a massive amount Monday afternoon (rising 15 bps), it also rose 15 bps last Wednesday (May 27) and fell 15 the following day. On Wednesday, the move was tentatively attributed to mortgage-related hedging as Treasury yields moved higher. On Thursday, there was no good explanation. Today, it's the GM bankruptcy. Forgive me for being skeptical.

Felix's final point, however, is the one that really surprised me:

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.

The implication, I believe is that interest rate swaps are different from "something else" (read: CDS) because they lack are a "zero-sum game" and lack "systemic implications."

But CDS are a zero sum game! In fact, I can't think of a financial asset that isn't a zero-sum game. If you follow the trail, it appears that Felix may be referencing either someone who commented on an article of his over at Seeking Alpha, or a different Seeking Alpha article - and you know how I feel about Seeking Alpha - which essentially argue that CDS are not zero sum because they have negative externalities (like requiring bailouts). But, if I may be cynical for a second, the bailout is the only thing preventing CDS from being zero-sum! Zero-sum means no dollars are invented or disappear; every one transfers one-for-one among involved parties. It does NOT mean that dollars are self contained. Saying CDS are not zero sum because they caused the meltdown of 2008 is like saying Russian bonds are not zero sum because they led to LTCM's bailout in 1998. Every dollar made comes from someone else's pocket. That's what zero sum means. Nothing more. Nothing less. The concept that any modern financial contract (including a Ponzi scheme!) is not zero sum is odd. The economic process itself is not zero sum, because wealth can be created (or destroyed), but derivatives thereof (contracts, if you will) are zero sum because every dollar made comes, effectively, from the counterparty. End of rant.

And to the other point, that interest rate swaps lack systemic implications - newly bankrupt Jefferson County, Alabama, begs to differ.

Felix also refers to negative convexity in his post, following it quickly with "don't ask" and a link to an incomprehensible article. I wrote on the topic a couple months ago, though I can't promise to be much more clear.

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