A Swapper's Paradigm

So a lot has changed since I last blogged. Most notably, the market has found two major deficiencies with the current conventions and ripped a hole straight through them. The first is the mortgage market and how the agencies work to keep order in the mortgage world. I'll write about that another time. The most fascinating change in my opinion (being a rates derivatives guy) is the changes that have happened in libor space.

Libor (the London Interbank Offer Rate), which I've touched on briefly in my Rates "Learn the Lingo" (http://getonthedesk.blogspot.com/2007/06/learn-lingo-rates.html), has seen some dramatic swings. Swap guys pay very close attention to libor because swap payments are set off of libor. While fixed payments are made at whatever rate was agreed upon, the float payments usually reset every three months according to whatever level the three month libor rate set that day.

Libor sets through something of a committee. Basically a bunch of member banks (16, I think) contribute rates at which they say they would offer to lend unsecured cash to other member banks. The top four and bottom four rates are discarded and the simple average is taken of the remaining eight. It is set sometime around 11:45 london time. Many tenors are published from overnight to one year. The most important are usually the overnight rate and the three month rate.

It's worth noting that the rates published by each bank are not necessarily the rates at which they actually lent money nor the rates at which they actually borrowed money (that seems kinda dumb to anyone? Yea, thought it might.). People had pointed out this deficiency before, but it never actually became an issue until recently. Swap and repo guys will know about turn of year funding issues, where year-end (literally dec 31st) and month end funding cost more because companies have to balance their accounting statements. Funding on those days are particularly expensive. The fed has had to flood the financial system with liquidity (read: give away money for free) on these days at times of crises to prevent companies from being unable to fund themselves (thus going bankrupt).

It turns out that this year a whole lot of these sorts of issues were happening and the liquidity of several companies were doubted. We've all heard of Bear Stearns and the "run on the bank" they had, making the older folks remenisce back to the Great Depression days when such runs on banks were common. Those involved also would have seen a similar process (and many rumors) take place with Lehman, although they turned out quite fine.

Libor starting setting higher and higher as banks started to hoard their cash. In fact, it got so bad that at one point the Fed having cut 100bps had completely priced out of the libor market. That is, libor was setting as high as it was when fed funds were 100bps higher. That was both ridiculous and showed how damaged the sytem was. Then the Fed came out with some of their cool toys, most notably the TAF and the dealer lending facility (the name of which evades me at the moment), to inject liquidity without lowering the funds rate. Down came libor again as panic averted and we came back into a "normal" market environment (or as normal as you can say 20bp moves every other day are).

At one point, the allegations came out about banks lying about where they were funding via the libor rates they contributed. Ironically, I think the most publicized version of this allegation came from a Citi analyst. Well, shortly thereafter libor rates started to skyrocket again as scrutiny around libor made member banks carefully set their libor closer to where they actually funded themselves (and citi's new libor rate was much, much higher).

At this point it might be worth noting that or "IBOR" rates aren't as retarded as LIBOR. Some of them, like Euribor, are set via a market rate or market average. That kind of makes sense, doesn't it? To be able to actually see where the rate should be via market transactions. Well, some people really started to notice this as their funding rates went through the roof and trounced their income margins.

Lately a movement has begun to move the derivatives market away from libor. The action itself makes sense, and a gradual transition of swaps and other derivatives away from libor would probably work. Specifically Goldman has suggested that OIS become the new benchmark rate.

What's OIS? OIS stands for Overnight Index Swap. No, that's not helpful. OIS is a swap that goes off of the fed funds effective rate (the rate at which banks lends excess balances to the Fed overnight--basically banks with more cash on hand than required can make a bit of excess interest rate by keeping it at the Fed). The fed funds effective rate is a transactional rate that anyone can observe (well, anyone involved in the markets, at least). The fed funds effective rate usually stays very close to the fed funds target rate, which is the rate the fed announces their policy cuts around at those FOMC meetings.

OIS swaps already trade a bit in the market, but libor swaps still dominate. OIS swaps make sense for people who are hedging, and the uncertanty around reset risk would go away for both dealers and counterparties. The overnight money markets are less active these days and there are usually very few longer dated transactions anyway (for example, why would a bank ever lend for 6months or a year at libor? It seems silly. The only rate really observable was the overnight rate for libor.). OIS, being tied to the specific set of fed funds effective rates, would make the value of interest rate derivatives much easier to predict.

It will be interesting to see if OIS ends up becoming the new libor over the next year or so. It seems the transition will be slow, and it will be a difficult transition to force. If all the dealers agree to trade OIS swaps instead of libor swaps, they'd still have to get customers to convert. For most institutions it probably makes sense to use OIS, especially those who are hedging rate risk for a balance sheet (specifically bank portfolios funding at the fed funds rate, which are a major player in swap space). For other institutions (i.e. industrial companies), it probably doesn't matter as long as they get some sort of interest rate exposure. Personally, I'd say never bet against those Goldman folks.