where o where has the risk free rate gone?
eventually to gold?
=DJ Swaps As A Benchmark Poses Systemic Risk Issues: CSFB
10 May 08:16
(This article was originally published Wednesday)
By Michael Mackenzie
Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)--Federal Reserve Chairman Alan Greenspan might have
adopted a sanguine tone when he spoke about the continued diminution of the
Treasury market last month, but one investment bank has warned that the
prospect of interest rate swaps replacing Treasurys as the fixed income
benchmark could create a nightmare for central bankers.
Acknowledging a future devoid of risk-free Treasury securities at a recent
meeting of the Bond Market Association, Greenspan expressed his optimism that
the financial market would be able to create alternative interest rate
benchmarks.
One alternative non-government measure that's garnered a strong presence
within capital markets in recent years is that of interest rate swaps,
derivative instruments that are structured around a contract in which one party
agrees to make payments at a fixed rate of interest while the other agrees to
pay a floating rate. But while they've rapidly become significant tools for
valuing, pricing and hedging corporate bonds, mortgage-backed securities and
agency securities, it's questionable whether they can adequately function as a
true benchmark in times of financial crisis.
"Private sector benchmarks are fine and good except in the (unlikely) case of
a systemic crisis," Credit Suisse First Boston analysts wrote in a research
note Monday. "Systemic risk remains a factor in the pricing of swaps."
On three occasions during the past three years, the swap market has
experienced distinct bouts of illiquidity. These include the near bankruptcy of
the hedge fund Long Term Capital Management in the aftermath of Russia's debt
default in October 1998, the Y2K panic of summer 1999 and the burst of monetary
tightening by the Federal Reserve in April-May 2000.
During these periods, the interbank swap market closed the shutters, with the
consequence that trades beyond even the standard size of $50 million became
difficult to execute.
The rationale for this inactivity lay in the overwhelming desire of market
participants to pay fixed on a swap contract. The strong one-directional flows
meant swap dealers were unable to accommodate the demand to pay fixed because
very few participants were willing to sit on the other side of the contract and
make floating rate payments when credit risks, and therefore private credit
interest rates, were rising.
Not surprisingly, CSFB said, swap spreads vaulted sharply higher during these
periods as dealers "raised their offer levels to sharply ration flows... you
could run, but you couldn't hedge."
One-Way Only
The dysfunctional nature of the swaps market in times of trouble is
compounded by the ongoing consolidation of the banking industry, which is
reducing the number of swap counterparties. The recent merger of Chase
Manhattan and JP Morgan has created a giant that dwarfs other banks within the
interest rate swaps sphere, a market that the Bank of International Settlements
estimated at $48 trillion in June last year.
At the end of last year, JP Morgan Chase & Co. (JPM) had a notional
outstanding amount of $13.5 trillion in interest rate swap contracts according
to Swaps Monitor Publications Inc, an Internet-based provider of global
derivatives data based in New York City. Trailing some distance behind in terms
of outstanding notional interest rate swap contracts were Bank of America Corp.
(BAC) with $3.8 trillion and Citigroup Inc. (C), which had a notional
outstanding amount of $3.7 trillion.
Although banks trading swaps between each other in the interbank market
pledge collateral to reduce counterparty risk, "the problem is that
private-name collateral is subject to the same systemic risk as the swap market
itself," the CSFB analysts wrote. This raises the specter that during a
financial crisis "all such collateral may became illiquid."
Given the track record of the swaps market and the present diminution of the
Treasurys market, CSFB argued that "the market appears to proceed under the
assumption that central banks will remain the ultimate guarantor of the swaps
market."
The rationale, CSFB said, is that a "systemic crisis" that would cause the
"interruption of current payments on interest-rate swaps would shut down the
world's financial system and cause incalculable economic damage, unless central
banks step in."
CSFB argued that the financial markets are ahead of the curve in believing
central banks would alleviate stress within the swaps market during a future
crisis, because they are pricing swaps at a significant premium to the debt of
the Double-A-rated banks that participate in the swaps market.
"For years we have heard the old wives tale that swaps simply were a generic
AA credit," CSFB wrote, noting that the credit of Double-A-rated banks actually
trades much lower than that of swaps. For example, Citigroup's recent 5-year
note issue, which received a Double-A rating from Fitch, was priced at 5.75%,
or 100 basis points over comparable Treasurys on Friday, at the same time that
the 5-year swap spread was trading at around 71 basis points over Treasurys.
"Clearly, the risk to swap transactions is identical to the risk of the
banking system," and this means "forcing the world to rely on private
benchmarks puts all the more onus on central banks to step in," CSFB said.
Hence a world depleted of Treasurys, which provide a source of low risk and
highly liquid collateral, and the ensuing reliance upon private benchmarks such
as swaps, pose significant dangers. A systemic shock could herald emergency
surgery from central banks, because in such a world "the entire banking system
has become too big to fail," CSFB said.
-By Michael Mackenzie, Dow Jones Newswires, 201-938-5451;
michael.mackenzie@dowjones.com
(END) DOW JONES NEWS 05-10-01
08:16 AM |
