Diary of a Financier

Interest Rate Risk- Part II

In Economics on Mon 2 May 2011 at 08:01
  • In terms of catastrophic potential, it’s improper to compare interest rate derivatives to CDS.
  • The future risk of interest rate derivatives depends on whether systemic institutions are using them to hedge or leverage their interest rate risk.

Continuing my quest to undress the US economy’s interest rate risk, I noticed a post by Graham Summers earlier last week.  Entitled “QE3 is Coming, It’s Just a Matter of Time,” the article is reminiscent of my own repeated insistence, as follows:

Come June, “HAMP 2″ will be the artist formerly known as “QE3”… With mortgages & housing being the real aims of stimulus, future stimulus needs to directly impact mortgages & housing… without any residual effect upon food & energy. HAMP 1 was wrought with corruption and idiocy, so I hope Washington takes a few months to carefully plan an effective sequel.

Along those lines, Mr. Summers comments:

The Fed will absolutely have to engage in some kind of QE. It might be a toned down version like QE lite (which supposedly doesn’t involve additional money printing). Or the Fed might try to make it a QE that would be more palatable to homeowners (targeting mortgage rates or some such thing).

However, the fact remains that the Fed HAS to continue with QE of some kind. The reasons for this are:

  1. The $180+ TRILLION interest rate based derivatives market (90+% all of which are owned by the TBTFs)
  2. The debt implosion a spike in interest rates would have
  3. Having become the primary buyer of US debt, the Fed must continue to buy or risk a debt collapse in the Treasury market   Whether or not you like QE (yes, there are some insane people who think it’s a good idea… unfortunately they work for the Fed), this is the reality our financial system faces.

I’m particularly interested in his comparison of interest rate based derivatives to Credit Default Swaps (CDS). Mr. Summers is absolutely correct that the notional value of interest rate derivatives dwarfs that of the CDS market, but it’s an imperfect comparison. The CDS debacle transpired [in simple terms] because it added another layer of leverage upon real estate assets via synthetic CDOs–most of which cheaply multiplied the exposure of too-big-to-fail (TBTF) institutions, rather than hedging that exposure.  Given all the leverage and all the counterparty risk, mortgage CDS faced a disorderly crowding-out when the panic hit full-tilt.  We’re not just talking wide bid/offer spreads; we’re talking no quote, no liquidity, your CDS contract isn’t worth the napkin its written upon.  On the other hand, the corporate debt CDS market operated quite regularly (or “perfectly dysfunctionally”) throughout the crisis… at least, using the equity/bond markets as a benchmark, corporate CDS met your garden-variety panic.

Thus, the biggest determinant to whether or not interest rate derivatives pose a systemic threat would lie in the data regarding systemic institutions’ net interest rate risk.  In other words, it depends on whether banks are turning to the $180T interest rate derivatives market to hedge their rate exposure (netting out exposure), or to leverage it.  TBTFs didn’t own 90% of the CDS market.  They were severely net short CDS on real estate, however, which compound the losses from real estate portfolios (mortgages, etc.).  I hope that’s not the case here, given zero-bound interest rates.

Mr. Summers proposes that TBTF banking institutions account for 90% of said market. Perhaps his figure compiles notional (not net) exposure, counterparty risk and clearing involvement. But I’m interested in how liquid the interest rate derivative (i.e. swap) market is functioning, because as we saw from players like Cornwall Capital & Michael Burry, malfunctions in the CDS market reared far before real estate’s demise.

There’s no doubt interest rate derivative could be another capital market snake eating its own tail.  Although there exist esoteric breeds, these instruments are generally well-understood and acknowledged widely by the Street; i.e. they don’t have a sneaking Black Swan potential.  (And, that’s not to say that the US doesn’t have a huge hurdle to surpass in ZIRP.)  I’m trying to do some digging to figure out the following, which could pose a grander threat:

  1. Are the interest rate derivatives at systemically important (TBTF) institutions net hedging or net leveraging proprietary interest rate exposure?
  2. Are these derivatives being packaged into synthetic products a la CDS/CDOs (and slapped with de jure AAA ratings)?
  3. Are those marketplaces functioning normally?

I will make a point to monitor the liquidity & spreads in this marketplace just in case I can catch a harbinger of a market correction.  I’m told liquidity is fluid at this time, but I have continued digging to undertake.


  1. […] light of my skepticism regarding interest rate derivatives a systemic risk, I thought I’d record a real suspicion of […]

  2. Tyler Durden & BNY’s Nicholas Colas weigh in…
    Basically, when Dodd-Frank forces all standardized OTC derivatives onto exchanges, three things will happen:
    1. Clearing companies will demand collateral, which is bullish for sovereign debt (US Treasuries).
    2. Because clearing companies require margins to cover them in the event of a counterparty default, major derivatives traders (banks) will have to raise cash to meet higher margin requirements than they’re used to in OTC markets that lack clearing intermediaries.
    3. Margin hikes in volatile markets (a la silver) could trigger selloffs in other asset classes.


  3. […] diverted a lot of activity in the interbank market into short-term T-Bills. Perhaps my focus on the interest-rate risk among American banks distracted me from the trump of global macro currents. I still expect a rising […]


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