Meet the Swaption Another $25 Trillion Time Bomb

by John Galt
July 11, 2016 00:15 ET

Wow. Another all time high in the S&P 500, just like 2007:

SPX_10YR_BSC_ALLTIMEHIGH_jgfla

In June of 2007, the S&P 500 hit an all time high price even as Bear Stearns was bailing out two major hedge funds which imploded due to the real estate crisis and complex derivative investment instruments (via the Wall Street Journal in 2007):

Two Big Funds At Bear Stearns Face Shutdown

Two big hedge funds at Bear Stearns Cos. were close to being shut down last night as a rescue plan developed over several days fell apart in a drama that could have wide-ranging consequences for Wall Street and investors.

Merrill Lynch & Co., one of the hedge funds’ lenders, said it would move to seize collateral — much of it mortgage-backed debt — from the two funds and sell it, according to documents reviewed by The Wall Street Journal. At the same time, the funds’ managers worked with a handful of other key lenders, including Goldman Sachs Group Inc. and Bank of America Corp., to pay off the funds’ $9 billion in loans, according to a person familiar with the matter.

As of a few weeks ago, the two Bear Stearns hedge funds held more than $20 billion of investments, mostly in complex securities made up of bonds backed by subprime mortgages — the relatively risky home loans made to borrowers with troubled credit histories.

In recent weeks, however, the firm’s High Grade Structured Credit Strategies Enhanced Leverage Fund and High Grade Structured Credit Strategies Fund have been besieged by investors and lenders trying to recover their money as the value of the funds’ underlying bonds fell sharply.

The Bear Stearns hedge funds’ problems are emblematic of the widening fallout from the nation’s housing downturn, which just a few weeks ago seemed to be stabilizing. During the housing boom in the first half of the decade, lenders issued record volumes of mortgages, often on very generous terms, then packaged those mortgages into bonds and sold them off, reducing their exposure to any loans that went bad.

Remember all that fun? Remember learning about CDS, ABS, CMBS, MBS, CDO, CDO², CPDO, and CLO’s (etc..)? Why don’t we take a trip down memory lane thanks to this scene from the movie, The Big Short (Language not appropriate for minors):

Thus another trip back to 2007 and recounting of memory lane is appropriate. No one could immediately figure out why all the derivatives on the market were not collapsing in 2007 even though banksters, mortgage originators, banks (small ones at that time), and hedge funds were imploding yet the stock market kept going to all time highs.

In fact, here is a great snippet from an article from Fortune on June 26, 2007 (linked in the title) to illustrate where we were then and now:

Has the bull market run its course?

 Oh, what a glorious first half it was for the stock markets this year! Share prices shrugged off recession warnings, they brushed off the subprime loan meltdown, and they scoffed at the Shanghai stock scare. By June 4 the S&P 500 index was up 9.4 percent for the year.

Then came the market equivalent of kryptonite – inflation! rising bond yields! – and the markets staggered before regaining form. As the second half of the year begins, stockholders are skittish, so we decided the time was right to consult Wall Street’s top sages and pose the question on every investor’s mind: Has the bull market run its course?

Not just yet. At least, that’s the consensus of the strategists we interviewed. The market will inevitably slump, they say, but that’s unlikely to happen in the second half of 2007. “Don’t panic,” says Wayne Lin, an investment strategy analyst at Legg Mason. “There doesn’t seem to be much out there to cause the market to tank in the next couple of quarters.”

It’s easy to see why investors are nervous. Six years of ultra-low interest rates have been a tonic for corporations, private-equity funds, consumers and, well, pretty much everybody other than income investors. Companies have lavished buybacks on their shareholders, and stocks have been propelled by a burgeoning wave of mergers and acquisitions. So couldn’t a rise in borrowing costs bring the party to a halt?

Surprisingly, Lin argues that rising rates and yields on longer-term Treasury bonds are healthy signs. “Rates have been so low for so long, in part because there was a lot of worry that the U.S. economy would tank and that the Federal Reserve would have to cut interest rates [to stimulate growth],” he says.

Yes, rates have risen, but only modestly (to 5.1 percent for the ten-year bond as of mid-June). And the crucial point, according to experts, is that they’re not about to soar. The Fed isn’t likely to jack up rates substantially this year, say six strategists interviewed by Fortune.

(Heck, it seems as if only minutes ago everybody was expecting a cut.) And even if bond yields float higher, the strategists say, there’s still plenty of room before there is real hurt put on the stock market. “We need to go to a 6 percent yield on the ten-year note to present an initial obstacle [to share prices],” says Quincy Krosby, chief investment strategist at the Hartford.

The surging rates and fears of inflation are blinding investors to the fact that the change is occurring for a happy reason: Economic growth is picking up. That could boost corporate profits and support stock prices. “People will buy equities in anticipation of production. They’re a leading indicator of growth,” says David Malpass, chief global economist at Bear Stearns. “Many stocks have been held back by overstated concerns about a slowdown in the U.S.”

The combination of economic growth and relatively stable interest rates should ensure that two stalwart trends of recent years – buybacks and buyouts – roll on a while longer. Moreover, international markets remain strong. Finally, there’s one nonfundamental factor that could help stocks, says Michael Metz, chief investment strategist at Oppenheimer.

And now for the money line from the article. The one which will make most sane people hyperventilate, scream at me, their computers, and possibly break out a legally owned firearm and destroy their display in an oh so glorious manner:

Alternatives to equities are not all that attractive. Real interest rates are below historical norms, and they’re heading higher, and that makes bonds relatively unattractive. The residential real estate market is no longer an option and commercial real estate is way overpriced.” It all adds up to a bull market for stocks – at least for a little while longer.

Are you f’ing kidding me?

That was when interest rates on 10 year US Treasuries were above 5%; I repeat 5%! now they are barely trading at 1.35%!!!!!

THIS is the STANDARD line on CNBS and the other financial circus networks plus from the regime, allegedly vigilant “journalists” and opinion makers about the condition of the markets and the economy. In 2007 they lied. So what makes anyone think they are not lying NOW?!?!?!?!

This brings my readers to the point where you say okay, awesome, I’ve relived watching 30% of everything I’ve invested in get vaporized because I didn’t listen to John Galt on the radio at that time and he warned about Armageddon and I said he was full of shit. So what? The Democrats forced through Dodd-Frank and that’s like putting Kevlar on a puppy so even a .50 caliber round can’t kill it, right?

Uh no, that puppy is toast.

From the Dodd-Frank Act, Title VII (via Sidley.com):

Title VII’s Definition of a “Swap”
Title VII of Dodd

-Frank includes in its definition of “swap”, subject to CFTC regulation, the following products:

•credit default swaps referencing a broad-based security index;
•credit default swaps referencing more than one loan
•total return swaps referencing a broad-based security index (whether comprising debt securities or equity
securities); or any loan index;
•total return swaps referencing more than one loan;
•equity variance and dividend swaps referencing a broad-based security index;
•correlation swaps referencing a broad-based security index and any commodity or commodity index (including FX, rates and rate indices/indexes);
•interest rate swaps;
•FX swaps and forwards (subject to potential exemp
tions that may be recommended by the Treasury Department);
•OTC options on or referencing any asset other than an option on a security or a certificate of deposit, or group or index of securities, including any interest therein or based on the value thereof;
•commodity swaps;
•weather, energy and emissions swaps;
•other swaps referencing broad-based (as opposed to narrow-based) securities indices, government securities and most other reference assets; and
•swaptions on any of the above.

At this point in time, my readers are probably asking why the hell would anyone invest in futures on the weather or carbon emissions?

Because they can, even if there is no redeeming investment or social economic value.

So what is a “swaption” and why should Americans give a crap?

Here is the definition via Investopedia:

What is ‘Swaption (Swap Option)’

A swaption (swap option) is the option to enter into an interest rate swap or some other type of swap. In exchange for an option premium, the buyer gains the right but not the obligation to enter into a specified swap agreement with the issuer on a specified future date.

BREAKING DOWN ‘Swaption (Swap Option)’

There are two different kinds of swaptions: a payer swaption and a receiver swaption. In a payer swaption, the purchaser has the right, but not the obligation, to enter into a swap contract where he becomes the fixed-rate payer and the floating-rate receiver. A receiver swaption is the opposite; the purchaser has the option to enter into a swap contract where he will receive the fixed rate and pay the floating rate. Swaptions are over-the-counter contracts and are not standardized like equity options or futures contracts. Thus, the buyer and seller need to both agree to the price of the swaption, the time until expiration of the swaption, the notional amount, and the fixed and floating rates.

Beyond these terms, the buyer and seller must agree whether the swaption style will be Bermudan, European or American. These style names have nothing to do with geography, but instead with how the swaption can be executed. With a Bermudan swaption, the purchaser is allowed to exercise the option and enter into the specified swap on a predetermined set of specific dates. With a European swaption, the purchaser is only allowed to exercise the option and enter into the swap on the expiration date of the swaption. With an American-style swaption, the purchaser can exercise the option and enter into the swap on any day between the origination of the swap and the expiration date. Since swaptions are custom contracts, more creative terms are also possible.
The Swaption Market

Swaptions are generally used to hedge options positions on bonds, to aid in restructuring current positions another swaps, with structured notes, and to alter an entire portfolio or firm’s aggregate payoff profile. Because of the nature in which swaptions are used, the market participants are typically large financial institutions, banks and hedge funds. Large corporations also participate in the market to help manage interest rate risk. Contracts are offered in most of the major world currencies. The large investment and commercial banks are generally the main market makers, because the immense technological and human capital required to monitor and maintain a portfolio of swaptions is usually out of the reach of smaller-sized firms.

Translation: You can not buy into this market but it could kill you.

In the Interest Rate Derivatives market, swaptions closed out the first quarter of 2016 with just over $25 trillion in active options traded:

SWAPTIONS_CREDIT_DERIVATIVES_2010_Q12016jgfla

So why is the collapse in swaptions volumes on global interest rate derivatives a potentially deflationary warning sign? Although it is only down 29% since 2011, the ongoing lack of new options plays on interest rates indicates an almost sedate attitude towards the actions of the Federal Reserve, European Central Bank, Bank of England, and Bank of Japan. Despite new highs in equities, the theory is that deflation, not inflation, is ruling the world’s economies and the only course of actions is to continuously pump money into a vacuum and pray that at some point economic activity uses the excess liquidity for direct investment instead of swapping and trading between central banks using global treasuries like shares trading in Pets.com during the late 1990’s.

In a $500 trillion interest rate swap derivatives market, if any mistake is made by ANY central bank via raising rates to any substantial realistic level, the wagers placed will cause a massive distortion in currency and interest rate derivatives and potential collapses across numerous Western financial institutions. Thus why the levered risk of swaptions could be a major indicator that deflation, not inflation will rule the world for the next five years plus to come regardless of central bank action and worse, create distortions which cause banks like Deutsche Bank and other older European, Asian, and North American institutions to collapse due to a liquidity squeeze created by diminishing economic activity and lack of ability to lever up profits using traditional banking practices.

Worst, how does the swaption trade kill our banks? Take a small instrument, say a put on the US Fed Funds Rate for $100 million to stay at 0.25% when suddenly Janet gets a wild hair up her rear and rates rise at the end of this year to 0.75%. For the average consumer this is pretty much meaningless; for the banksters on the wrong side of the trade holding a put option for 0.25% to 0.01% they are a billion bucks in the hole or more depending on the unsupervised settled price. Worse? What if those swaptions were sold to other banks, European banks, Japanese banks, all not properly hedged? It feels a lot like 2008 all over again then. Now think about the implications for the big players which come to mind like say, oh, Deutsche Bank, Citigroup, etc. if they are not properly hedged since many of the formulas used are based on only 5 years of historical data; not 10 when the last crisis would be enveloped into the bankster’s quantative hedging strategy.

Sadly for Asia and the U.S., a continuous deflationary tidal wave means that the US Dollar and Japanese Yen will increase dramatically in valuation putting more pressure on prices and wages within their respective domestic economies causing a collapse of pricing power in South America, the Middle East, Europe, and any nation which pegs their currency to the US Dollar. Thus I think it is time to stop watching traditional methods for measuring deflationary warning signs and time to watch what few indicators the “dark pools” set up for us outside the truly regulated markets. If anyone thinks the CFTC (Commodity Futures Trading Commission) has any ability to regulate or monitor daily, much less weekly or monthly activity and actions withing the derivatives markets, much less understand them, I would say that someone is clinically insane.

We have returned back to 2007 with no sanity, no regulators, and no leadership. As the calendar accelerates economically much faster than that time period due to technological improvements and governmental incompetence the question is no longer if, but when.

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