Interest rate swaps - the Cliff Notes version...

djf

[djf]

I, like many people, have heard many of the terms relating to the economy and banking and not understood them very well. Terms like hedge funds, derivatives, counterparties, and interest rate swaps. I probably still don't.

A couple weeks ago, I heard a fellow on the radio give basically what can be called a "Cliff Notes" version of what an interest rate swap is, who is involved, what it means for the economy, etc.

Here is what he said, paraphrased, and I thought it was important enough to share with FReepers, and you can come to your own conclusions about whether it is a good thing or a bad thing.

Let's say a city wants/needs to borrow money. Since we are told over and over that we have a "debt driven" economy, that's a good thing, right?

Well assuming the city is going to borrow, it has two options: Fixed rate, or variable rate.

Traditionally, variable rates can be had cheaper. If that was not so, then they wouldn't exist at all, because who would borrow at a variable rate if he could borrow at a lower fixed rate?

The city decides "OK. We'll go for the variable rate. The only problem is, if the rate goes up, we'll get creamed!"

Along comes our White Knight, some kind of Hedge fund or banker or TBTF.

They say, out of the kindness of their hearts, "OK. Here's the deal. If you pay us X percent of the loan on a continuing basis, we will carry the risk of an interest rate hike."

In other words, if the rates go up, the financial institution will pay the difference.

The city thinks about it and agrees. because what they have done is basically bought a fixed rate.

The financial institution has in a sense engaged in a kind of reverse capitalism. They have immediate cash flow, based on something they may or may not be required to do in the future.

In a sense, it's a kind of insurance policy.

Now comes the problem. If interest rates go up, even by a small amount, the financial backers stand to lose not a couple thousand bucks, not a million or even a billion. Current estimates of the value of the interest rate market according to Wiki are in the neighborhood of THREE HUNDRED FORTY TRILLION DOLLARS!!!

SO!

Interest rates CAN'T go up! It would decimate the TBTF's! These rates are all determined by the Fed Reserve Prime Rate and London's LIBOR rate.

And this is why QE3 is here. And why QE4 is coming. And QE5, and QE6, etc. They have painted themselves into a corner! They have to keep this crazy paper swap going, because if interest rates go up, it's light out! No checks processed! No ATM's! No bank loans! Locked bank doors! Retirement accounts disappearing in the blink of an eye!

Now you can jump over to Wiki and read about interest rate swaps and you will be deluged with stuff about what if it's in the same currency or different currencies, etc. blah blah blah blah...

But the basic description here is sound.

Think about it and plan accordingly!

Interest rate swaps. The nail in the coffin!

[L,TOWM]

Google the term “financial repression” for nice primer on what savers (or more importantly, people that have to live off of the RETURNS from their savings) have to look forward to for the next decade.

Assume an inflation rate of 3%. With the government’s debt being out to mostly the 4-7 year range, that extrapolates to positive return of 2.25 for our government for every dollar of debt issued today at a rate of around .75%. Now look at what Japan has been dealing with for the last 20 years. There’s the American economy until 2030 (at least) or, to put it bluntly, when the boomers start dying off in large numbers.

[djf]

Bump. Give more people a chance to see what’s going down...

[Travis McGee]

She’s gonna blow, it’s just a question of when.

[djf]

I think it will be external pressures that do it.

We are already seeing movements away from the USD as the reserve currency, and I read into the Bernanke announcement that the Treasury auctions are doing less and less of the funding.

Eventually they will start trading oil in something other than dollars...

What’s kept it going so long is our wheat and our weapons.