Today's Market Observation 01.25.2010 Mon Tue Wed Thu Fri Kirby Archive
Interest Rate Roulette
BY ROB KIRBY | january 25, 2010
According to the most recent data from the U.S. Office of the Comptroller of the Currency, the notional value of derivatives held by U.S. commercial banks increased $804 billion in the third quarter of 2009, or 0.4%, to $204.3 trillion.
Seven banks hold 99.8% of all derivatives:
Source: Office of the Comptroller of the Currency
Derivative contracts remain concentrated in interest rate products, which comprise 84% of the $204.3 trillion total derivative notional values.
Trading revenue arising from ALL derivatives trading by all U.S. commercial banks was $5.7 billion in the third quarter of 2009, up 11% from $5.2 billion in the second quarter:
To further understand how 7 banks made more than 5 billion dollars in revenue trading interest rate derivatives in 3 months we must first understand the interest rate landscape. The yield curve for U.S. Government debt itself along with corporate spreads [how much of a premium a corporate pays for debt relative to the government] determine bank’s profitability in trading interest rate derivatives.
We’re now going to concentrate on U.S. Government yield curve itself and the most common trade utilized to speculate on the shape of this curve – Interest Rate Swaps:
Source: Office of the Comptroller of the Currency Pg. 22
So what is an Interest Rate Swap:
An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR).
Remember, an interest rate swap is an exchange of cash flows – fixed for floating. Now, since the largest commercial banks made over 5 billion trading “fixed” for “floating” rates in the latest quarter – given the shape of the government yield curve depicted below - WE KNOW that the commercial banks are being paid “fixed” [higher longer rates] and in return, the commercial banks must be paying “floating” [lower short term rates].
What the commercial banks are “earning,” it goes to reason that their counterparty is “losing”. This raises a serious question; who is on the losing side of the commercial bank’s interest rate swap trades?
Source: Office of the Comptroller of the Currency, Pg. 9
While it’s not conclusive, the following announcement might provide some valuable clues in solving this mystery. The U.S. Government in its [misguided] wisdom feebly ‘set up’ the high-rollers - Fannie and Freddie as ‘easy marks’ at this Christmas Eve turkey-shoot:
U.S. promises unlimited financial assistance to Fannie Mae, Freddie Mac
The Obama administration pledged Thursday to provide unlimited financial assistance to mortgage giants Fannie Mae and Freddie Mac, an eleventh-hour move that allows the government to exceed the current $400 billion cap on emergency aid without seeking permission from a bailout-weary Congress.
The Christmas Eve announcement by the Treasury Department means that it can continue to run the companies, which were seized last year, as arms of the government for the rest of President Obama's current term.
But even as the administration was making this open-ended financial commitment, Fannie Mae and Freddie Mac disclosed that they had received approval from their federal regulator to pay $42 million in Wall Street-style compensation packages to 12 top executives for 2009…
The commercial bank’s balance sheets are being rehabilitated through the guise of saving Fannie and Freddie [the housing market]. Whatever the commercial banks are making from interest rate swaps – in the absence of legitimate end-users - is someone else’s loss, and it’s all being monetized.
Who do you think is really picking up the tab?
Today’s Market
Overseas equity markets began the week on a negative note with Japan’s Nikkei Index losing 77 points to close at 10,512. North American markets ignored that with the DOW ahead 23.90 to 10,196.90, the NASDAQ adding 5.51 to 2,210.80 and the S & P gaining 5.05 to 1,096.80. NYMEX crude oil futures added .60 to end the day at 75.14 per barrel.
On foreign exchange markets the US Dollar Index lost .11 to close at 78.16.
Benchmark interest rates saw the 5 year government bond end the day at 2.36% while the 10 year bond finished at 3.64%.
The precious metals complex ended the day mixed with COMEX gold futures ahead 5.50 to 1,098.00 per ounce while COMEX silver futures added .14 to 17.15 per ounce. The XAU Index lost 1.09 to close at 157.69 while the HUI Index lost 5.44 to end the day at 398.45.
On tap for tomorrow, at 9:00 a.m. Nov. Case-Shiller Index data is due – expected -4.6% vs. prior -7.28%. Then at 10:00 a.m. Jan. Consumer Confidence data is due – expected 52.1 vs. prior 53.3. Also at 10:00 a.m. the Nov. FHFA Home Price Index data is due – expected .3% vs. prior .6%.
Wishing you all a pleasant evening!
Rob Kirby
Registered Representative
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