PBoC managing China's rising interest rates

Interest rates in China have been on the rise. The 7-day repo swap rates have been increasing across all tenors. These swaps exchange the 7-day repo rate (reset weekly) for a fixed rate over a longer period (such as 2 years) - thus providing a window into the market's long-term expectations of repo rates. The increase is an indication of tightening liquidity conditions in the interbank market.

2-year fixed for floating  (7-day repo) swap rate (Bloomberg)

China's central bank has been trying to add more liquidity to the money markets in order to stabilize rates (without adjusting the bank reserve ratio).

WSJ: - The People's Bank of China injected 220 billion yuan ($34.7 billion) into the money market Tuesday via reverse repurchase agreements offered in its regular open-market operation, continuing efforts to ease monetary conditions and bolster a slowing economy.

So far these liquidity injections have not worked, as demand for short-term money remains high and rates continue to rise.

Reuters: - China's key money rates ticked higher on Tuesday, with the central bank's largest fund injection since early July failing to ease conditions amid elevated month-end cash demand and corporate tax payments. The People's Bank of China injected 220 billion yuan into the banking system via reverse repos on Tuesday, against a net 87 billion yuan scheduled to be drained this week due to maturing bills, repos, and reverse repos.

That guarantees a net injection of at least 133 billion yuan for the week not including additional reverse repos likely to be auctioned on Thursday. Such an injection would be the largest since the week of July 2-6.

"The market demand is quite large. Monday's demand was really heavy. The central bank's action today basically just satisfied current demand, but didn't in any way exceed it in a way that would bring rates down," said a trader at a city commercial bank in Shanghai.

The PBoC has been cautious about flooding the market with liquidity due to risks it could reignite inflationary pressures. Yet left unchecked, rising interest rates could threaten growth, given that the GDP is already growing at the lowest rate since 2009. This will require a delicate balance for the central bank going forward.

China GDP YoY (Bloomberg)

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Rate swaps have an embedded option to sue the bank

This happened in the US and is now happening globally. Municipalities, corporations, and even sovereign states who put on "hedges" against rising interest rates are suing banks because their hedges lost money. Let's see, you put on a position that will make money if rates rise, what do you think happens if rates fall?

10-year EUR swap rate

But that's OK because many organizations always have the option to sue the banks to recover these losses.

Bloomberg: - Unitech Ltd., an Indian property developer, accused Deutsche Bank AG of selling it an interest- rate swap that wasn’t suitable and wasn’t properly explained, according to a London lawsuit over a $150 million loan deal.

That's right, the hedge wasn't explained well. It's way too complicated. If interest rates rise, Unitech's property development funding costs go up and the swap makes them money to offset those incremental costs. If rates go down and funding costs decrease, the swap loses money and Unitech loses the savings from lower funding costs.

Or maybe they don't have to give up those savings after all - because they can just play dumb and default on the swap payments.

Unitech filed a counterclaim in May arguing Deutsche Bank was negligent to sell an unsuitable hedging agreement, and owed damages that canceled out its debt, according to court documents. Germany’s biggest bank had earlier sued Unitech saying a unit of the company owes $11 million under the swap contract and has missed payments.

Deutsche Bank “knew, or must have appreciated, that it was likely to make significant amounts of money” from the contract at Unitech’s expense, the Indian company said in its lawsuit. 

Of course Deutsche Bank knew that rates will go down. They always know which way rates are going.

Interest-rate swaps that turned out to be costly for customers and profitable for banks have led to hundreds of lawsuits and an investigation by the U.K. Financial Services Authority into how they were sold. Unitech’s suit is one of the largest to reach the U.K. courts. The issue has affected bank customers from British seaside cafes to municipal governments including Milan in Italy and Jefferson County, Alabama.

Banks make a spread on swaps they transact with clients. In general they offset the rate risk with futures, bonds, or swaps in the other direction (usually some combination of these). A typical swaps desk is indifferent to the detection of rates. That means if the client loses money, doesn't mean the bank makes that same amount of money, because the bank is rate neutral. Unless of course the client refuses to pay.

This option to sue really comes in handy. Here is some investment advice: if you have a stock portfolio, hedge it with some S&P500 futures. If these futures make you money when your portfolio tanks, you've limited your losses. But if the futures lose money when the portfolio rallies, just sue the Chicago Mercantile Exchange. Wait, that might be a bit tough to do. Instead of futures, just enter into an equity index swap with some bank, and then sue it in some "friendly" jurisdiction. Just claim it wasn't well explained to you.

These swap sales people at banks need to be re-educated. They should only offer cancellable swaps to most clients. Such swaps allow a client to cancel the transactions if rates go against them. Cancellable swaps are clearly more expensive than the "vanilla" type because of that embedded option to cancel. But since many organizations already have a free embedded option to sue, the cancellable product is the way to go (see quick overview below).


Cancellable swap

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Italian bureaucrats learned Rate Swaps 101 at Harvard

Here we go again. Confusion reigns supreme about Italy's so called "derivatives bets" on which Morgan Stanley collected some 2.6 billion euros. Lets look at some media quotes.

Reuters: Education Undersecretary Marco Rossi Doria made the announcement in answer to a parliamentary question after U.S. investment bank Morgan Stanley said it had received 3.4 billion euros to close derivatives contracts with Italy's Treasury.

The Italian government has made the same error that Harvard University made some years back. See the post called Harvard's big swap unwind from 2009. Italy, with its numerous municipal capital projects had always been concerned about rising interest rates. If rates were to go up they reasoned, their financing costs will go up as well. So as the Euribor rates came down some time ago, they figured they would lock in what they thought at the time were attractive financing rates. The government put on swaps and some swaptions that would rise in value if the long term swap rates were to rise (to compensate them for rising funding costs). But swap rates kept falling in 2011 as the Eurozone was looking into the abyss.

10yr EUR swap rate (Bloomberg)

Unfortunately for Italy, their funding rates completely decoupled from swap rates. Swap rates represent the forward expectation of Euribor (for the next say 10 years). These rates were elevated relative to German bunds, but were still declining as German rates kept falling. So not only was Italy losing money on the swaps because of lower swap rates, but the nation was also having to pay much more for funding because its sovereign credit risk increased. This is an example of "basis risk", when your hedge decouples from what you are hedging and both end up going against you.

To add insult to injury, Italy also got downgraded to a level that triggered the swap/swaption unwind.

Reuters: He said the contracts with Morgan Stanley, made up of two interest rate swaps and two swap options, were closed under an "Additional Termination Event" clause.

These co-called break clauses are rare in contracts involving sovereigns, and the clause was only present in the Treasury's contracts with Morgan Stanley, Rossi Doria said.

"Additional Termination Event" clauses are common under ISDA agreements. Some of these clauses basically state that if one counterparty's credit deteriorates, the derivatives contracts in place between the two counterparties terminate. So Morgan Stanley terminated the contracts with Italy based on the downgrades and received the unwind value.

Of course the media hype out there makes it sound as though Morgan Stanley suddenly made 2.6 billion euros. It didn't. Its swaps were hedged - so whatever it made on Italy, it lost on the hedge and other offsetting trades (except for the initial spread).

The media confusion gets even more strange when they try to reconcile the numbers between what Morgan Stanley reported on its books and what Italy actually paid them.

Reuters: He did not account for the discrepancy between the 2.567 billion euros he said the Treasury had paid to Morgan Stanley and the 3.4 billion euros referred to by the bank in its report to the U.S. Securities and Exchange Commission.

There is nothing to "account for". Not all the contracts with Italy have been unwound and Morgan Stanley was showing its mark to market (unrealized) gains. So Italy is taking more pain than the 2.567 billion euros they paid out - the remaining losses just haven't been realized. It's unclear if Morgan Stanley has or can call for margin as was the case with Harvard.

The more troubling point is the size of Italy's swaps still outstanding.

Reuters: He added that the state still has derivatives contracts worth some 160 billion euros, or nearly 10 percent of the 1.624 trillion euros of Italian bonds in circulation.

Because these are off balance sheet, it is unlikely that they are reflected in Italian government's overall liability measure. But even if these swaps are under water by say 10% (very roughly, 100bp move in swap rates times duration of 10), it will add another 1% to Italy's outstanding debt. 16 billion - extremely painful, but not the end of the world for Italy.

The media confusion continues (don't mean to pick on Reuters - other outfits like Bloomberg are just as confused):

Reuters: Italy's use of derivatives to guarantee its public debt yielded a loss of 2 billion euros in 2011 in the form of higher interest payments and 4 billion euros in 2007-2010, official figures show.

Guarantee? There is no guarantee here. The reporter here must be confusing rate swaps with CDS - two slightly different contracts. These are just interest rate hedges gone terribly wrong. Apparently the Italian bureaucrats responsible for these hedging programs went to Harvard to learn how it's done.

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OIS spread - compare & contrast

The USD OIS (overnight index swap) spreads continue to stay elevated. The chart below shows the spread between the 2-year LIBOR swap (IR swap) and the 2-year OIS. This is the market expectation of 3-month LIBOR for the next two years vs. the market expectation for the interbank overnight rates for the next two years. The spread between the two is the market expectation for the next two years of premium on the 3-month loan rate vs. the overnight loan rate.

2-year OIS spread (2-year rate swap rate - 2-year OIS swap rate) (Bloomberg)

That means the market anticipates a prolonged tightness in dollar term funding even though the Fed is expected to keep the overnight rates near zero.  The next chart shows the current LIBOR curve vs. the OIS curve.  Without this premium for term funding, the two curves would be right on top of one another.  But we have OIS curve following the Fed's trajectory - overnight rates near zero for the next two years, while LIBOR is "not listening" to the Fed because of the term funding premium.

 LIBOR Curve vs. OIS Curve (Bloomberg)

In contrast, here are the same two curves in 2005 when "balance sheet usage" for term funding was not a concern.  Those were the good old days.

 LIBOR Curve vs. OIS Curve (Bloomberg) on 11/29/2005

Elevated OIS spread indicates banks' increasing fears of lending to each other for longer than overnight and is a good gauge of financial stress.

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Harvard's big swap unwind

As we discussed a few months back, Harvard's lesson in Asset/Liability management had indeed been costly. What has come to light recently is the pain Harvard took on their interest rate hedges. As the school went on their construction spree and undertook a variety of capital projects in the last few years, they were running exposure to short-term rates. This was due to the way the university was financing these capital projects (which is typical for such financing).

In order to lock in their short-term rates on the capital projects' debt, they swapped floating for fixed (agreeing to pay fixed rate and receive floating). Simple enough. But as the rates collapsed late last year, Harvard got a massive margin call on the swaps. Again, this is standard - the value of the swaps went against them (they continued to pay the same fixed rate but were expected to receive floating rate that's significantly lower) and banks called for margin. In principal, that should be OK as well, because the swap losses should be offset by Harvard's lower financing costs.





But a couple things went wrong. Some of their capital projects were put on hold, so they couldn't take advantage of cheap financing. At the same time their liquidity in the endowment became significantly constrained because of the nature of their illiquid investments. And with the economy collapsing, unencumbered donations nearly dried up. The margin call was much more than they could handle and Harvard ended up issuing bonds to cover losses. They ultimately decided to get out of their exposure (possibly at the worst time.) They unwound some $1.1 billion of swaps. However, rather than unwinding the remainder of the hedges (and paying the losses upfront), they simply locked in the losses with offsetting swaps, creating a long-term liability stream. Here is the statement on the offsetting trades:

Harvard (see attached): ... in fiscal 2009, the University entered into additional interest rate exchange agreements with a notional value of $764.0 million, under which the University receives a fixed rate and pays a variable rate. These new interest rate exchange agreements, or ‘offsetting’ agreements, were intended to reduce the risk of further losses in value (with associated collateral posting requirements) within the portfolio of interest rate exchange agreements.

In fact this unwind and others like it at the time caused the 30-year swap spreads to go negative. The overall impact on Harvard's financials was severe:

Bloomberg: Harvard paid $497.6 million during the fiscal year ended June 30 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects, the report said. The university in Cambridge, Massachusetts, said it also agreed to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps.

So how can a bunch of really smart people run into so much trouble with a hedging program. The consultants out there are shouting - you should have hired us to do this. This is too complex for you Harvard guys.

Bloomberg: “It says that people don’t understand the complexity of the products they are buying and selling that doesn’t begin and end with mortgage securities,” said Robert Doty, a municipal finance adviser at American Governmental Services in Sacramento, California. ... “It shows that with these products that are so highly complex, people are a long way from knowing as much about these products as they think they do,” he said.

"so highly complex"? This is how this particular consultant gets paid, by making sure that everything in finance is "too complex" to do without his guidance. In fact this is not about complexity, it's about the practicalities and appropriateness of financial products. And this is when academia often fails - the rule of "we must hedge everything with swaps" was put in place by someone who is not only clueless about the simple mechanics of margin, but also doesn't understand the purpose of hedging.

What is the purpose of hedging here? For Harvard it was to avoid paying really high rates on their financing. But what is high? If LIBOR was at 4.5% when they started on their projects, would it be that difficult for them to pay 5% or 6%? Probably not. The real pain would kick in above say 8%. Hedging for this type of situation should be viewed as a form of insurance. And as we all know, when you buy insurance, the cost depends on your deductible. So Harvard instead of entering into swaps, could have easily bought some interest rate caps struck at say 8%, making sure they never have to pay above that level. It's a high deductible, making these caps reasonably inexpensive. In retrospect it would have been money wasted, but as with any insurance, you buy it hoping it will be wasted.

Alternatively, if they didn't want to pay upfront premium for caps, they could have put on cancellable swaps. The right to cancel would have made their fixed payments higher (depending on maturity, maybe a percent more). But they could have simply cancelled them last year with no breakup costs or margin call. It's a standard and fairly liquid product (in the category of "swaptions"). Of course some would say - oooo, this is too exotic. This concept is actually commonplace, as the "option to cancel" is built into most people's mortgage. When mortgage rates drop, most can refinance with no penalty of unwinding the old mortgage (something borrowers generally can't do in the UK for example). If you refinanced your mortgage before, you've exercised your "option to cancel".

The media is making this sound as though it's a "bad investment" gone wrong - mostly because they don't understand the situation, and it creates good hype. In reality it's simply an issue of sound asset/liability management, proper usage of financial tools, and a bit of common sense. Makes for a good Harvard Business Case study.


Harvard- Financial Report

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Steepening forward curve increases credit risk for swap providers

As corporations continue to issue bonds, some choose to convert their fixed rate liabilities into a floating rate. The reason is that LIBOR has fallen to historically low levels. For corporate treasurers it's worth taking interest risk in order to 1-month or 3-month LIBOR plus spread.

For example if a company issues a 7% coupon 10-year bond, it can swap it into floating rate by receiving fixed on a swap (at 3.8%) and paying LIBOR. That converts their liability from 7% to LIBOR + 3.2% (7 - 3.8 = 3.2). With 3-month LIBOR currently at 0.43% the financing cost becomes 3.63%. Of course if at some point in the future, LIBOR goes to 6%, the cost will jump to 9.2% - but that's a risk worth taking for some. Some corporations think that if LIBOR increases significantly, the economy is supposedly doing better (otherwise the Fed would keep short-term rates low), and the company should be able to afford higher coupon payments.

But what about the bank that enters into that swap? It turns out that with the forward LIBOR curve as steep as it currently is (see chart below - the curve is significantly steeper than 3 months ago), the bank is taking more credit risk. If rates do what the forward curve is predicting, then in the earlier years the bank is a net payer to the company (red arrow on the chart below) . In the later years when forward LIBOR is higher than the locked in swap rate (purple line on the chart below), the bank is a net receiver of cash (blue arrow).



Well if the bank is first a net payer and then in later years it's a net receiver, this is effectively a loan to the company. Now rates never actually follow the forward curve, but that's the starting point for assessing the bank's credit exposure. The steeper the curve, the larger the effective "loan" (initial outflows), the more credit risk. The bank then runs a simulation on how volatility may impact rates to measure a "stress scenario" exposure (sometimes called "potential exposure"). If this exposure is large enough, the bank will sometimes purchase a credit default swap on the company. If rates go high enough, the company will owe the bank increasing periodic payments, and if the company fails to make those payments, the bank can use it's CDS position to reduce or eliminate losses.

Of course CDS costs money, and depending on the company's credit quality, the bank will add spread to the swap they do with them. In the example above, rather than transacting the swap at 3.8%, the bank will agree to pay say 3.6%, making the company's financing expenses LIBOR + 3.4%. And the steeper the curve gets, the higher this spread will become. As LIBOR stays low and the credit markets stay open, the demand for these swaps continues to stay strong.