Greek Debt Plunges as Hedge Funds Kept Away

* Greece - sold 5 billion Euros of 7 year bonds yesterday. This morning the deal is about 25 bps higher in rate. Supposedly, the buyers of yesterday’s Greek debt issue were mostly accounts who were told to participate in the sale. Also, in yesterday’s sale, the underwriters were told to eliminate hedge funds from being eligible to participate. I am sure the hedge funds are happy about this today. While hedge funds are not likely to be Greece’s long term buy and hold account, they do play an important function in the market via the liquidity they provide. Hedge funds also create an appearance of demand, which in turn, helps bring other buy and hold accounts into the market. The proof is in the pudding. Since yesterday, Greek debt yields are up 20 to 25 bps, while German debt yields are down by 2 bps and Portugal debt yields are up by a modest 2 bps. In other words, the sale did not go very well, as evidenced by the increase in Greek debt yields today, versus nominal changes in the yields on other European sovereign debt. Bring back the hedge funds!


While I am on the topic of Greece, it remains to be seen as to how well the austerity plans which have been announced and legislated, actually play out. While Greece might go a step further to reducing their budget deficits, what will happen to their economy as these austerity measure ripple through their economy. While Greece’s tax collection record sucks, as evidenced by the fact that only 2 people report earning over 1mm euros, the folks who will take a pay cut are those on the government payroll, who pay taxes because the government is their employer. In other words, by cutting public payrolls, Greece will be also cutting into their own revenue streams.


* Swap spreads – as I have shown in previous blog entries, even though swap spreads are near, or below zero, it does not mean that banks can borrow money at less than the US treasury rate, unless they rely on the vagarities of rolling over short term debt. Nonetheless, the prevalence of negative 10 year swap spreads has created a bit of a stir amongst us fixed income geeks. Here are a couple of other comments on this subject:


1>    Many commentators like to cite hedging corporate debt issuance for the downward pressure on swap spreads. If a borrower is hedging the rate at which it will be able to borrow, they will pay on swaps (which upward pressure on swap spreads) when they initiate the hedge, and receive on swaps when they unwind these hedges and their debt is issued, putting downward pressure on spreads. When these hedges are unwound, is when you hear about corporate issuance putting pressure on swap spreads. But the bottom line is that all hedges place equal upward and downward pressure on swap spreads when they executed, for a zero net effect.


2>    Over the last 18 months, the Fed and treasury has purchased $1.625 trillion of agency MBS or debentures. This amounts to about $7 trillion of duration. Typically, agency and MBS are owned by end investors, and hedge funds. Hedge fund participants typically hedged with swap spreads. To the extent that hedge funds sold their holdings over the last 18 months, into the massive government bid, then that would have them unwinding their swap hedges, which in turn would have put downward pressure on swap spreads. Let’s carry this one step further and assume the hedgies wanted to bet on widening MBS spreads as the Fed ends their MBS purchase program: they would short MBS, and receive on swaps, which would put additional downward pressure on swap spreads. While it is inconclusive, I would bet that this has had some impact on falling swap spreads over the course of the last year.

Look at the attached graph, which shows 10 years of history between the FNMA MBS 30 yr rate, versus the 5 year swap rate. This spread is leaning to the wide end of the recent range. If the Fed’s purchase program was truly having an impact on swap spreads, then I would not expect to see this spread pushing its wides. Either that, or there is a tremendous amount of pressure on this spread, indicating that many players are short MBS, and long swaps. If that is the case then this represents a huge pool of market players who will eventually unwind these positions, which in turn will provide a floor on swap spreads. This is the best conclusion which this relationships suggests, in my opinion.


3>    There has been some chatter about the size of the losses which will be realized by banks from the negative swap spreads. Various articles have cited bank’s large exposures to swap spreads. I did some research and have determined that banks have about $142 trillion of interest rate swap exposure on their books. Of this amount, about 90% of it nets out, and only 10%, or $14 trillion represents true exposure to changes in interest rate swap rates. There is no credible information in the public domain which tells you who is on the winning side of these positions, as swap spreads drop below zero.