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Peter Tchir wrote a piece
yesterday describing yet another hole in the banks’ balance sheets:
I am not sure I fully
understand it, but to me it looks something like this:
A bank has a duration
mismatch. Its funding is short-term, which means it must be rolled over
frequently. This subjects the bank to the risk of a rise in interest
rates, which would make its cost of funding higher. And of course if
rates rise, then the market value of the bond it bought is lower.
So when they go to buy a new
bond, they also buy an interest rate swap. The calculus is as follows:
1) if interest rates fall,
their funding will get cheaper (a gain), the bond they bought will go up in
value (a gain), and the swap loses value (a loss);
2) if interest rates rise,
their funding will get more expensive (a loss), the bond will go down in
value (a loss), and the swap will rise in value (a gain)
By calculating the
amount of swaps to buy, the bank thinks it is controlling its risk. The
bank wants to make a pure spread: Interest on bond – funding cost
– swap cost.
But today as Mr. Tchir
writes, the problem is that the bond is losing value not because rates are
rising but because the issuer is in trouble. So the swap is not
providing the protection that the bank hoped for. The bank’s
funding costs may or may not be falling, but it is certainly taking a loss
from the fall in the price of the bond due to credit risk and a loss due on
the interest rate swap as well.
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