Negative swap spreads hit bank capital buffers

Portfolios of asset-swapped US Treasuries see mark-to-market losses of up to 20bp

Swap spread inversion has hit bank buffers

Negative swap spreads have taken a bite out of banks' capital buffers, with summer moves by European firms to invest in US dollar-denominated assets compounding the pain for some.

"Swap spreads have now become negative, so asset swaps at intermediate maturity are now trading at a Libor-positive spread, so that implies if you bought asset swaps a year ago, right now you are under water," says a senior rates trader at a European bank in New York.

Banks in the US and increasingly Europe hold US Treasuries in their liquidity buffers and hedge the duration risk with asset swaps, exchanging the fixed interest rates from holdings of cash Treasuries and receiving Libor plus a so-called asset swap spread. The trades leave banks exposed to the spread between swap rates and the US Treasury yield, which is usually positive as swaps carry more credit and liquidity risk than government bonds.

US swap spreads, however, turned negative in September and hit an all-time low on November 5, when the 10-year swap spread fell to negative 17.6 basis points. As of December 9, the 10-year swap rate was 2.14%, while the yield on 10-year Treasuries was 2.22% – a negative 8bp spread. This has left banks with mark-to-market losses in their liquidity portfolios, which is deducted from banks' capital buffers.

"You have the spread between the bond and the swap, and when the net present value of the package is negative, you have a loss on that position," says the head of asset/liability management (ALM) at a Nordic bank.

Some ALM desks switched out of euro holdings and into more US dollar holdings, even though it wasn’t in line with their true liquidity needs or ALM requirements

Opportunity cost

The loss can be seen as an opportunity cost of holding an asset swap that pays the buyer less than an asset swap pays today. The asset swap spread is partly based on the interest rate swap rate subtracted from the US Treasury yield – not to be confused with the interest rate swap spread, which is the US Treasury yield subtracted from the swap rate.

So when Treasury yields were below the interest rate swap rate, the asset swap spread was negative, meaning buyers of the asset swap would have locked in a receive position where they are paid Libor minus a spread. When Treasury yields rose above the swap rate, the asset swap spread turned positive, meaning buyers entering the swap now could receive payments above Libor – resulting in mark-to-market losses for those holding older positions with negative asset swap spreads.

 

Banks that entered into asset swaps when the spread was negative may have lost around 15–20bp on those legacy trades. "Treasury yields were trading on average at 5bp below the swap curve, and now they are trading at 13bp above the swap curve, so in mark-to-market terms, they would have lost between 15bp and 20bp," says the head of rates at another large European bank.

US banks are likely to be worst hit, but European firms are also bracing for losses after increasing their holdings of US Treasuries in recent years to improve diversification and capitalise on the higher yields relative to European government bonds.

"Some ALM desks switched out of euro holdings and into more US dollar holdings, even though it wasn't in line with their true liquidity needs or ALM requirements. They might be right in the long-term, but they're clearly wrong in the short-term," says the European bank's head of rates.

The losses will not hit bank profits, however. Government bonds purchased to satisfy a bank's liquidity requirements are usually held in its available-for-sale (AFS) portfolio, along with the swaps used to hedge the duration risk on those assets. The AFS portfolio is subject to fair value – or mark-to-market – accounting.

However, losses and gains in the AFS portfolio do not impact a bank's profits. Instead, they are unrealised and flow through to its accumulated other comprehensive income, which only hits the firm's Common Equity Tier 1 (CET1) capital.

According to the European Banking Authority's (EBA) latest transparency exercise, the five largest European investment banks – Barclays, BNP Paribas, Deutsche Bank, HSBC and Societe Generale – had combined US sovereign exposures of €85 billion ($93 billion) in their AFS books at the end of June, up from €76 billion at the end of 2014. HSBC, Barclays and Societe Generale had the largest exposures, at €35 billion, €28 billion and €14 billion respectively, with BNP Paribas holding €7 billion of US sovereign exposures and Deutsche Bank reporting just €414 million.

ALM experts say banks use asset swaps to hedge most – if not all – the government bond holdings in their liquidity buffers. These trades are typically done on a bond-by-basis, as an overlay strategy would not qualify for hedge accounting treatment.

€170 million losses

To illustrate the potential hit, if asset swaps had been used to hedge €85 billion of US sovereign exposure at the end of June the mark-to-market loss would have been in the order of €170 million.

The EBA numbers were from June 30, and some claim actual losses could be higher than those figures imply, as some European banks increased their US dollar holdings over the summer.

"Their thinking in the summer was that the spread between the Bund asset swap and the US Treasury asset swap – which was around a 35bp differential – was a bargain for them. But now that 35bp has gone to 50bp or 55bp, so they're losing money," says the head of rates at the European bank.

A third European bank shifted around $1 billion – or 2.5% of its liquidity portfolio – from Central and Eastern European government bonds to US Treasuries and European agencies denominated in US dollars, according to its head of ALM hedging.

"Reinvestment in euro high-quality liquid assets (HQLA) is quite unattractive if you want to avoid southern European exposure, and since we have some natural liquidity in US dollars, we decided to buy US Treasuries instead and some European agencies in US dollars," he says. "The other reason was diversification, as we will sooner or later face the 25% CET1 limit for a single sovereign."

However, he insists the shift to US dollar assets will pay off in the long term: "We understand that in asset swap terms, the spread is negative, but the absolute yield is also important for us, and if our expectations materialise that the Fed hike will be delayed and less severe, the choice was a much better alternative than euro HQLA."

The mark-to-market losses would only be crystallised if the trades are unwound, which bankers say is unlikely as the duration of the positions is probably low enough to be held to maturity.

"I wouldn't guess anyone is realising the loss. It depends on how long you have invested. There is much greater spread risk sensitivity if you invested in 10-year US Treasuries and swapped them down, but banks tend to invest in the shorter part of the Treasury curve," says the head of ALM at the Nordic bank.

Many banks will also be spared from recognising the full extent of the mark-to-market losses because of the way the Basel III capital requirements are being phased in – only 60% of unrealised gains and losses in AFS portfolios are currently being factored into a bank's CET1 capital.

Filtering out gains and losses

The European Union's capital requirements regulation, which implements the Basel II requirements in the region along with an accompanying directive, also gives national regulators the discretion to allow banks to filter out gains and losses in the AFS portfolio from their capital calculations. However, some national governments – including the UK – opted to remove such filters regardless. Some European banks also chose to stop applying such filters even where permitted in order to take advantage of unrealised gains in the AFS portfolio – only to see those gains turn to losses when swap spreads turned negative.

 

There is much greater spread risk sensitivity if you invested in 10-year US Treasuries and swapped them down, but banks tend to invest in the shorter part of the Treasury curve – Head of ALM at a Nordic bank

 

"We were filtering out the impact, but that wasn't the case for all banks, as some were thinking opportunistically and not cautiously, and didn't want to filter out the positive mark-to-market. They will have to take the hit of this in their equity. Given the move on bonds globally, the mark-to-market was hugely positive, but from our point of view, it is absolutely not safe to take this filter off, because we know it can also go the other way around," says the ALM head at a third European bank.

The recent paper losses have not dissuaded European banks from increasing their holdings of US Treasuries, however. Indeed, the carry available with US Treasuries coupled with negative swap spreads has made them more attractive for future investments.

The amount of US Treasuries European banks can hold in their liquidity buffers is capped by the amount of dollar funding they have – as the cost of purchasing Treasuries with euro funding would entail the use of expensive cross-currency swaps – and by liquidity regulations, which require banks to hold assets in the same currency as potential outflows.

Still, some banks say they will look to obtain more dollar funding in order to load up on US Treasuries.

"Dollar funding is cheaper in terms of volume and cost, even for relatively domestic or Europe-centric banks. So I think you will probably see more and more banks doing issuance in dollar and using these dollars to buy US assets. Some of them may swap euros, but I think even without that you will have banks that will increasingly issue in dollars," says the chief of finance at a fourth European bank.