Those of you who saw The Big Short, probably found yourself frustrated watching Christian Bale’s character call Goldman Sachs to get his credit default swaps priced only to listen to the other end of the phone call tell him that swaps on mortgage-backed securities are a separate market from the mortgage-backed securities upon which the swap contracts were based. So even though the securities were losing value, Goldman wasn’t repricing Bale’s character’s swaps that were designed to gain as mortgage bonds deteriorated.
While post-2008 financial regulation has accomplished a lot and probably will accomplish more, signs of newly fragmented markets should signal to regulators areas where they need to walk back or make adjustments. While next to no one thinks that the so-called “Dodd-Frank” financial regulation bill sent us in the wrong direction, even Dodd and Frank know the new regulatory environment certainly isn’t perfect either. As the FT reported last November (Why Are Swap Rates Below Bond Yields?), swap spreads—the spread between Treasury yield and fixed rate on a swap of the same maturity—have gone and stayed negative in this post-crisis world. Theoretically, swap rates should carry a higher interest rate their corresponding Treasury yields as there is more counterparty risk when entering into a swap contract with a private institution as opposed to buying a Treasury bond from the U.S. government—which has never defaulted. Indeed, historically, swap rates typically held double-digit-basis-point spreads over Treasury yields. As the article indicates, due to post-crisis regulation, banks face tougher capital requirements for expanding their balance sheets, including into Treasuries and repurchase (“repo”) operations, and thus can be less responsive to the price dislocation and others who wish to use the dealer to arbitrage from the negative spread.
The arbitrage trade would look like this: A dealer (bank) enters into a repo contract (typically, on behalf of a hedge fund), thus lending securities for cash at a short-term borrowing rate—which it lends to the hedge fund at similar (but higher) short-term rate. The fund then uses the cash to buy a Treasury bond that is yielding more than its corresponding swap rate. The fund can then enter into a swap contract to pay the fixed interest rate—which, when the swap spread is negative, is less than it’s receiving in interest on the bond—and receive the floating rate which would offset the interest payments on the repo. Thus, the fund pockets the difference between the Treasury and spread rates.
As was demonstrated in The Big Short, fragmentation was a big factor in 2007/8—mortgage bonds improved leading up to the crisis despite a worsening housing market and then when mortgage bonds did begin to deteriorate, the offsetting credit default swaps did not immediately begin rising in value. Granted, any fragmentations in today’s markets do not have nearly the scale and severity of what we saw in the financial crisis. However, if the ability to arbitrage is lost, as appears to be the case already in swap markets due to tougher regulation on dealers, market prices can again run away from their underlying economic fundamentals (as they already have begun to in the swap market). Given the impetus for the last decade of new regulations, market fragmentations should be a topic at the front of regulators’ minds.