Robert O and Katherine...perhaps the following excerpts can explain my concern about collarteralization.... It does mention freddie and fannie ...but they are just part of the picture...
"First, let's look at the definition of an Interest Rate Swap – "a contract in which two counter-parties agree to exchange interest payments of differing character based on an underlying notional principal amount that is never exchanged." Basically, a swap just allows the exchange of interest rate risk from one party to another. While there are many variations of swaps, their recent spectacular growth is certainly associated with the proliferation of leveraged speculation that has become endemic to our financial system. Whether it has been the over-enterprising hedge funds and securities firms that leverage mortgages, asset-backs, junk bonds and agency securities in the repo (repurchase) market, or Fannie and Freddie that aggressively use money market borrowings to finance their bloated balance sheets of mortgages, or companies such as GE Capital and GMAC that borrow in the money markets to finance holdings of various loans and receivables, these strategies of borrowing short and lending long create significant interest rate risk. And in this vein, remember that our financial sector increased borrowings last year by more than $1 trillion, in what largely amounted to one massive interest rate arbitrage.
Many speculators incorporated the use of swaps and other interest rate derivative products, thus basically shifting some of their interest rate risk to the writers of these swaps and helping mitigate interest rate exposure. The writers of these swaps were more than happy to book the premium charged for these products right to the bottom line, expecting that they would hedge their risk if rates began to rise. A particular type of instrument became very popular, a so-called swaption. "A swaption is a contract on an interest rate swap. The contract gives the buyer the option to execute an interest rate swap on a future date, thereby locking in the financing cost at a specified fixed rate of interest. The seller of the swaption, usually a commercial bank or investment bank, assumes the risk of interest rate changes, in exchange for payment of a swap premium."
Valuing these types of swaps with embedded options can be very tricky and writing such exceedingly volatile derivatives is a most risky endeavor, as many have learned this year. Another risky instrument that has become quite commonplace is the inverse floater. An Inverse Floater is often a mortgage-backed bond, usually part of a collateralized mortgage obligation bearing an interest rate that declines as an index rate, for example, the LIBOR rate, increases. The agencies have made these quite attractive, particularly to the speculators, with enticing, above-market yields. However, with interest rates rising and spreads widening sharply, there have been significant losses suffered in this area. Remembering how many of these types of instruments blew-up in 1994, we wonder when we will again hear the term "toxic waste". Putting all of these derivatives and instruments together, there should be little mystery as to why our credit market has become so unstable.
Today, the key point to recognize is that with interest rates moving sharply higher after a period of unprecedented credit excesses, leveraging, speculation and financial engineering, the massive, virtually systemic, interest rate arbitrage has faltered badly. Huge losses have been suffered and our acutely vulnerable credit system is today impaired. Now it will just be a matter of time until we find out how these losses will be shared among investors, financial institutions, the leveraged speculating community and their insurers, the derivative players. Actually, however, we do tend to lump the derivative players in with the leveraged speculating community. All the same, we just can't shake our nervousness when we compare today's $25 trillion of notional interest rate derivatives to the $7 trillion that existed at the end of 1993. After all, there were certainly enough derivative-related fiascoes in 1994 with $7 trillion outstanding. Here, the old mountain versus a mole hill adage seems appropriate. Also, keep in mind that to this point the Fed has only raised rates 25 basis points, so we could potentially be very early in this process. Today, there is simply so much uncertainty weighing on the credit markets as to the health of the key derivative players as well as general confusion as to how this will all work. With $100 trillion of derivatives globally, we are much in uncharted territory that is reflected in heightened risk premiums.
In this context, today there is absolutely no transparency to judge how some of these major players are weathering the storm. Combined, Fannie and Freddie have $500 billion in derivatives, but one can discern little from their financial statements in determining if they are indeed adequately hedged. They could be in fine shape or in big big trouble, but there is simply no way to know. Looking at Chase Manhattan, with the largest notional derivative exposure of any institution, they had $10.4 trillion of total derivative positions at the end of the first quarter, including $5.4 trillion of swaps and $3 trillion of forward contracts. Is their book properly hedged or is their derivative portfolio an accident waiting to happen? Again, there is absolutely no way to know. All the same, there is no doubt that many players in the marketplace have suffered great losses and this has led to a general dislocation in the swaps area with players left pondering the soundness of the entire market. Yesterday, 10-year swap spreads increased to as wide as 112, the highest since 1987. For comparison, this spread had not traded above 100 this decade, even during last fall's near financial debacle. This spread began June at 79 and was 71 at the beginning of May. Additionally, the key TED spread, or the interest rate differential between Treasury and Eurodollar yields, widened almost 8 basis points yesterday, a quite notable one-day move. Even today, with a bond market rally and major stock market advance, the TED narrowed just 1 basis point to 85. The TED began June at 52.
But we will be the first to admit that all this seems rather moot on a day where the Dow gained 184 points and the S&P Bank and NASDAQ100 indices advanced 4%. And while the bulls and the pundits will celebrate today's benign inflation report, it is largely irrelevant to the big picture. |
