Current Strange Swaps Spreads: What do they mean?

A swap spread is the difference between the fixed rate equivalent (on the market) for LIBOR over a given period and the treasury bill rate for the same period. Normally they are very close, with the LIBOR swap slightly higher than the T-bill rate, presumably because there's a chance of default on the swap.

Recently, we have seen a very strange (historically) result. Short-term spread have been astronomical - over 4% for a short period - while long-terms spreads have been very low - down to 0% briefly yesterday. So what could this mean?

The fundamentals of the swap spread are easiest to understand in terms of an investor's choice. An investor with money to invest over a certain period could buy either a swap, from a financial institution, or a Treasury. If he buys the swap, he takes on a risk of default by the swapper; if he buys the Treasury he takes on a risk of default by the US government. An investor will also have to pay a fee to the swapper for the interest rate risk, which will normally increase with the length of the swap. For the investor to be indifferent, the following equation must hold (ignoring uncertainty):

Swap rate - interest fee - swapper default risk = Treasury rate - treasury default risk.

So the swap spread at equilibrium is

interest fee + swapper default risk - treasury default risk.

High short-term swap spreads are easy to explain: high default risk by the swappers (banks and other financial institutions). Many financial institutions have large unrecognized but likely losses and default is a real risk. But why is the long-term swap so low? Simple: although the short-term risk of a treasury default is low; long term it's fairly high. High enough, actually to outweigh both the substantial risk of swapper default *and* the interest rate risk for a 30-year swap.

Is this crazy? No, not at all. Suppose the US government was in Argentina's financial situation. Long-term LIBOR swaps might not be very different, but government bonds would be paying over 25% and the swap spread would be huge - and negative.

So current swap spreads are making a prediction: that the US government will assume so much debt that over 30 years its default risk substantially exceeds that of a typical major financial institution. While not certain, this is a rational prediction based on recent government actions. Governments worldwide have declared the intent to cover financial institution losses or give them capital, with the US having the most generous giveaway, a purchase of 125 billion in 5% preferred stock (less than half market rate) in 9 major banks.

Given the magnitude of current losses - estimates are as high as 5 trillion - if the government continues with a giveaway strategy it could certainly assume staggering losses and debt. Add in expenses to deal with the depression the credit markets are predicting and the US government could easily raise its default risk above that of current financial institutions.

I think this risk shows the government must be more cautious and efficient in its bailouts. It can't just hand out money to any financial institution that needs it, without any effort to clear the books or make investors take appropriate losses. A government struggling with default imposes enormous costs on its society. Taxes necessarily become extortionate and essential services skeletonized.

The events of the past few years have shown that we need a capable and responsible government which responds to the needs of the general population. But the markets are warning us that if we allow the government to continue unrestricted giveaways to the rich and well-connected we will lose that.