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Recently,
Bloomberg News reported that a legal brouhaha has developed in Italy surrounding the municipality of Milan entering into a refinancing
package, including retiring older existing debt and associated interest rate
swaps, with a combination of new bonds and interest rate swap agreements
designed to protect Milan
against a rise in long-term interest rates, back in 2005. This financing was arranged with a
quartet of banks including J.P. Morgan Chase, U.B.S. AG, Deutsche Bank AG and
Depfa Bank Plc.
The
consternation arose this year when the 1.69 billion swap agreement Milan
had signed with the banking counter-parties produced a mark-to-market
accounting loss amounting to many millions of Euros. The unanticipated mark-to-market loss,
which would only be realized / become payable if Milan were to cancel the
existing financing arrangement, is now cited by Italian authorities as
grounds by Italian authorities to seek fraud indictments on institutions and
individuals involved in the deal alleging the principals never adequately
disclosed to Milan that these swap deals held risks and expenses by as much
as 599 times more than the stated .01 [one basis point] per cent for advice.
The
Bloomberg article delves in to the question of whether there was a crime
committed in these actions. I
suspect that there is adequate evidence pointing to criminal activity –
but not likely the kind of criminal activity that Bloomberg thinks they are
reporting and Italian authorities are investigating and trying to prove.
Let me explain:
To get a
flavor for what long term rates were back in 2005
when this financing was arranged, we can visit archives of the
U.S. Federal Reserve which record historical 30-year fixed interest rate swap rates [these rates = 30 year U.S. gov’t
bond yield + a spread that fluctuates]:
Take
note that we heard nothing negative in the media from Milan
during 2006 or 2007 while they were enjoying “mark-to-market
gains” on their financing package.
The
notion that or the extent to which this quartet of banks adequately disclosed
whether interest rate swaps could produce mark-to-market losses; we cannot be
sure, but, one might consider that when the refinancing occurred in 2005
[when Milan cancelled then existing swaps] – Milan had to make
compensatory cash payments to their former Italian bankers [UniCredit SpA] to exit existing
swaps. So the notion that Milan
didn’t understand that new swaps would carry the same associated risks
is a ridiculous non starter.
So What Makes This Milan Deal [and others like it]
Really Stink?
Despite
the unfortunate situation that Milan
and its finances appear to be in, one must realize that these mark-to-market
pratfalls are the double-edged nature of derivatives where end-users of these
instruments may find themselves when expected or anticipated outcomes fail to
materialize.
From the
chart below, from the U.S. Office of the Comptroller of the Currency, we can
see that, in aggregate, the parabolic growth in the trade of derivatives is pyramidal in structure, serves no
observable or commercially productive purpose – because, aside from the
Milans of the world [isolated exceptions relative
to the scale of the market], THERE ARE
VIRTUALLY NO END USERS FOR THESE PRODUCTS:
source:
Office of the Comptroller of the Currency, Q3/07 Quarterly Derivatives
Report
This begs the question - What
is the REAL REASON for J.P. Morgan
Chase to assemble an interest rate derivatives book – which at Sept.
30, 2007 stood at 61.5 TRILLION in notional?
 
source: Office of the Comptroller of the Currency,
Q3/07 Quarterly Derivatives Report
The
answer becomes clear when one stops to realize the effect that this elephant-sized interest rates derivatives
edifice [specifically interest rate swaps] exerts pressure on the global
interest rate complex.
Here’s how:
Hedging Mechanics
of Interest Rate Swaps > 3 yrs. Duration
Interest rate
swaps > 3 yrs. in duration customarily trade as a "spread" -
expressed in basis points - over the current yield of a corresponding
benchmark government bond. That is to say, for example, 5 year interest rate
swaps [IRS] might be quoted in the market place as 80 - 85 over. This means
that the 5 yr. swap is "bid" at 80 basis points over the 5 yr.
government bond yield and it is "offered" at 85 basis points over
the 5 year government bond yield. Let's assume that 5 year government bonds
are yielding 1.90 % and the two counterparties in question consummate a trade
for 25 million notional at a spread of 84 basis points over. Here are the
mechanics of what happens: The payer of fixed rate pays [1.90 % + 84 basis
points =] 2.74 % annually on 25 million for 5 years. The other side of the
trade - the floating rate payer - pays 3 month Libor on 25 million notional,
reset quarterly - typically compounding successive floating rate payments at
successive 3 month Libor rates so that actual cash exchanges are settled
"net" annually. To ensure that the trade remains a "true
spread trade" [and not a naked spec. on rates] and to confirm that 1.90
% is a true measure of where current 5 year government bond yields really are
- the payer of the fixed rate actually buys 25 million worth of physical 5
year government bonds - at a price exactly equal to 1.90 % - from the
receiver of the fixed rate at the front end of the trade. So, in this regard,
we can say that 25 million IRS traded on a spread basis creates a
"need" for 25 million worth of 5 year government bonds
- because it has a 5 year bond trade of 25 million embedded in it.
- Interest rate swaps of duration < 3
years are typically hedged with strips of 3 month Eurodollar futures
instead of government bonds.
In
recent years the Chicago Mercantile Exchange [or CME] has developed an
interest rate swap - futures based hedging product for the 5 and 10 year
terms. I acknowledge the
existence of these products but due to their 200k contract size and amounts
traded, as reported in archived CME volume data, they do not materially
impact the numbers in this presentation.
As demonstrated, Interest Rate Swaps create demand
for bonds because bond trades are implicitly embedded in these transactions.
Without end user demand for the product – trading for “trading
sake” creates ARTIFICIAL
demand for bonds. This manipulates rates lower than they otherwise would
be. In short, there are not
enough U.S. Government bonds IN
EXISTENCE to adequately “hedge” J.P. Morgan’s interest
rate derivatives book.
That’s why we can deduce that these interest rate derivatives
are, in fact, the “undeclared” [stealth] central plank of U.S.
monetary policy.
The
detailed math that explains how many bonds, of maturity between 3 and 10
years, are required to “hedge” an interest rate swap book the
size of J.P. Morgan’s is explained in detail here in a
paper titled, The Elephant in the
Room.
This
paper goes on to show how the Federal Reserve and J.P. Morgan act in concert
as a single entity and how they’ve NEUTERED
USURY, engineering long term interest rates down to preposterously low,
uneconomic levels by overwhelming traditional self-corrective free market
forces. The EXTREME growth of the interest rate derivatives market has had NOTHING to do with offering interest
rate protection to end-users like Milan and EVERYTHING to do with ensuring that ANY AND ALL U.S. Government bonds issued find a home on favorable terms for the issuer that maintain and
perpetuate global U.S. Dollar hegemony.
So, the
real crime here is more like – Why are J.P. Morgan Chase et al selling
“interest rate protection” to the likes of Milan et al when they KNOW that usury has been neutered and
that interest rates are not going to be allowed to appreciably rise because
they are 100 % complicit in the interest rate suppression racket?
In case
anyone is still wondering – this explains the REAL REASON why and how institutions like J.P. Morgan and Goldman
Sachs [institutions known for their close ties to the Fed and U.S. Treasury]
are constantly “so much smarter” and such “better
fishermen” than all their competitors. The reality is that they “trade”
– by and large – in KNOWN
OUTCOMES. It’s like
fishing in a barrel!!!
Folks
would do well to realize that Deutsche Bank AG and U.B.S. AG are nothing more
than the German and Swiss equivalents in the global derivatives racket that
J.P. Morgan Chase is in the United
States of America. We only get a peek at the size of
American bank’s derivatives positions – the Europeans [Germans,
Swiss, French and British] to do not divulge / publish the size of their
financial institution’s derivatives books.
The selling
of “interest rate protection” in this manner is eerily familiar
to mob’s protection rackets that Italian investigators have been so
accustomed to dealing with, with varying results, throughout their
country’s history.
Let’s
see if they decide to combat it.
More for subscribers including, The Story Behind the
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Rob Kirby
KirbyAnalytics.com
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articles by Rob Kirby
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