MONDAY, JULY 21, 2014
by GEORGE BOLLENBACHER
With all the discussions about: 1) the coming (sometime) global increase in interest rates and 2) the need to margin outstanding swaps positions, not much has been said yet about what happens when these two events intersect. So it’s time to take a close look at the storm that will occur when these two clouds on the horizon come together.
First let’s see if we can figure out the impact of an increase in rates on the rate swaps market. First we’ll look at variation margin, and we’ll start by assuming that there are $500 trillion of rates swaps outstanding, and that the average tenor is 6 years. If we assume that short rates rise 100 basis points, that means there would be an increased annual payment on the floating rate side of $5 trillion. If we present value that over six years at 4%, it comes to a little under $26 trillion. So, if we were to mark the rates swaps to market at that point and apply variation margin, we’re looking for $26 trillion in cash. Of course, some of these swaps are back-to-back, which would reduce the net amount. But, even if we assume that 75% are back-to-back, that still leaves about $6.5 trillion to be raised.
Then we’ll look at initial margin. Let’s assume that half of the swaps are not collateralized, and half of those will have to be under the new rules. The important question is, what is the appropriate IM for a 6 year rate swap? Let’s say for the moment it’s 1.4% of the notional. That results in an increased IM of $1.75 trillion. Thus, for the floating rate payers in our category (currently unmargined that will have to margin) there will be a $6.5 trillion cash VM call and a $1.75 trillion securities IM call. For those already margined, or not requiring IM, the VM cash call under our assumptions would be just under $20 trillion. It is clear from this that, under these assumptions, the VM requirement would dwarf any IM requirements.
Finally let’s look at the situation for the fixed income securities that will be used as IM, or may have been repo’ed to supply the cash for the VM. Let’s assume that the average maturity of those securities is 5 years and the coupon is 4%. Marking $500 trillion of those notes to market for a 100 basis point rise in rates would reduce the value (and thus increase any haircut) by about $20 trillion, just at the time when the swaps market is looking for up to $26 trillion more in cash and about $1.75 trillion more in collateral. Given that there is already talk of a collateral squeeze, these are not good numbers to reflect on.
Faced with those increased payments, floating rate payers are going to want to terminate their positions, but that, of course, will simply turn the VM into a one-time payment. Thus the key to fixing this problem before it happens is wholesale compression of open rates positions. Whether floating rate payers are ready to do that before the storm arrives is, obviously, what markets are all about.
