But the inversion remains in the 30-year spread, which is around -20bps as I write. And that has persisted for most of the past couple of years, so there is still a mystery to explain.
Last time, I described a “financial perpetual motion machine” built from such a negative spread. Some people dismiss such constructs out of hand, since everyone knows free money — like perpetual motion — is impossible. But I believe you can learn something by examining one and figuring out exactly where it fails.
Recall the negative swap spread perfect arbitrage: Borrow short at LIBOR; use that to buy Treasuries; swap the fixed Treasury coupons for (floating) LIBOR; use those payments to pay interest on the short-term loan; and roll the short-term loan every three months.
What could possibly go wrong?
First, nothing really requires zero capital. But I do not think this is the answer. I suspect a perfectly-hedged structure like this would not tie up much capital — even regulatory capital — but I admit my knowledge of accounting rules is insufficient to be certain. Regardless of such regulatory constraints, I also suspect large banks would find a way around them if it meant truly risk-free money. Besides, the inversion in the 30-year is so large and has lasted for so long… Perhaps capital constraints were sufficient explanation in early 2009, but surely by now somebody would have come up with the capital to fund such a pure arbitrage?
Second, the U.S. Treasury might decide not to pay your coupon some day. This is the “US default-risk meme”, and like Bond Girl, I am skeptical. (Although anything is possible. Anybody know a free source for monitoring U.S. Treasury CDS?)
Third, the counterparty on your plain-vanilla swap might decide not to make his or her payment some day. But I consider this even less likely. Never mind that swaps are collateralized… If defaults started happening in the swaps market — the multi-hundred-trillion-dollar global swaps market — that would be even more of an Armageddon than U.S. sovereign default. Governments and central banks around the world would almost surely step in before the dominoes even started trembling.
Fourth, and finally, you might not be able to roll your loan every three months. Maybe you think this is obvious; “of course” you cannot be certain that you will be able to roll a short-term loan. But recall our hypothesis: “You” are a large bank borrowing in the London interbank market, and you have a swap paying LIBOR. If you are having trouble rolling your loan, then LIBOR is skyrocketing. Indeed, the definition of LIBOR is precisely the rate at which a large bank can, in fact, roll that loan. Since the swap payments track LIBOR, they should always be sufficient to fund the loan, no matter how expensive it becomes.
The punchline: LIBOR is a fiction.
â€œThe Libor rates are a bit of a fiction. The number on the screen doesnâ€™t always match what we see now,â€
complains the treasurer of one of the largest City banks.
â€œThe screen will say one thing but people are actually quoting a different level, if they are quoting at all,â€
says one senior banker.
The London Interbank Offered Rate, or Libor, has been driven sharply higher as banks have adopted the fetal position, reluctant to lend to each other because of need for their own cash. But those rates may not tell the entire story.
What theyâ€™ve found Thursday morning is an even greater reluctance to lend to each other than is expressed in Libor rates. Lou Crandall, chief economist at Wrightson ICAP, a subsidiary of ICAP, says the Thursday New York three-month rate was 3.71%, or 0.51 percentage point above Libor.
You can find similar stories throughout the crisis. What we learned in the last 2½ years is that the British Bankers’ Association will lie about LIBOR during times of financial distress. So if you enter this hypothetical arbitrage on (say) the 30-year swap spread, and sometime in the next 30 years another financial crisis develops, you may find that the variable side of your swap — which tracks the BBA’s reported LIBOR — is insufficient to cover your true cost of borrowing.
The BBA falsified LIBOR because they were trying to avoid making matters worse. I believe inverted swap spreads are an unintended consequence. Theoretically, swap spreads represent “systemic risk”, both current and anticipated. But if that were ever true in practice, it certainly is no longer, because we now know that LIBOR becomes understated during systemic events.
In fact, I would argue that a negative swap spread represents the market’s discounting the risk of another meltdown. Which is the exact opposite of what it is supposed to mean. How ironic.