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The Next Financial Bomb – IRS

No, it’s not the Internal Revenue Service, it’s Interest Rate Swaps, and with notional values in the hundreds of trillions (~$418 trillion as of mid 2008), and the sudden sharp jump in interest rates (10 year bond rates up more than 70% on the year), these are likely the next time bomb derivatives to explode on the balance sheets of the major banks.  They are tremendously complex and confusing instruments, but it boils down to this: if a bank is ‘short the swap’, they have to pay a floating rate to the counterparty.  In a rising interest rate environment, these payments grow, and theoretically, have no cap.

With Obama’s $3.55 trillion dollar budget, at least half of which will be financed by borrowing, and foreigners reducing purchases of this debt, this forced the Fed to announce their ‘quantitative easing’ plan of buying govt long-dated debt.  This was meant to support the 10yr and 30yr govt bond prices, but the effect was very temporary, with the 10yr yield immediately dropping from over 3% down to 2.5% that day (March 18), but has  since shot up to 3.76% .  Even the two year bond has jumped in yield, to 1.27% from under 1% just a couple weeks ago.

Record treasury issuance, quantitative easing programs at other central banks, and a resurgence of the commodity bull market (crude is up 110% from its lows 6 months ago) are driving rates higher and making Bernanke, Geithner, and the ‘too big to fail’ banks quite nervous.  These interest rate swaps are the latest Wall St. Frankenstein monster climbing out of its cage.

Thanks to Market Skeptics.com for providing lots of data and explanation on interest rate swaps.

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