U.S. Department of the Treasury

Office of Debt ManagementMay 4, 2010Presentation to theTreasury Borrowing Advisory Co
Agenda

2 

•Fiscal Developments•Auction Demand•Portfolio Metrics Update•Long-Term Challenges
FISCAL DEVELOPMENTS

3
Tax Receipts Are Showing Signs of Improvement

4

-50%-30%-10%

10%30%50%

Mar-00

Jun-00

Sep-00

Dec-00

Mar-01

Jun-01

Sep-01

Dec-01

Mar-02

Jun-02

Sep-02

Dec-02

Mar-03

Jun-03

Sep-03

Dec-03

Mar-04

Jun-04

Sep-04

Dec-04

Mar-05

Jun-05

Sep-05

Dec-05

Mar-06

Jun-06

Sep-06

Dec-06

Mar-07

Corporate Taxes Withheld Taxes Nonw

Note: Adjusted for 9/11 Corporate Tax Receipts disruption

Quarterly Tax ReceiptsYear over Year Percentage Change

A closer lCorporateWithheld: Nonwithh

Note: Data plotted is the yea
April Tax Receipts Breakout

5

Receipt Category As % of Annual Receipts As % of April ReceiptsWithheld 68% 39%Corporate 14% 11%Nonwithheld 18% 50%

5-Year Average Receipt Composition

A Closer Look at April 2010

Receipt Category Composition Y/Y % Change Withheld 46% 5% Corporate 11% 17% Nonwithheld 43% -17% 
TARP Repayments

6 

-$150-$125-$100

-$75-$50-$25

$0

$25$50$75

$100$125$150

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

May-09

Jun-09

Jul-09

Aug-09

Sep-09

Oct-09

Repayments, Dividends, Interest (LHS) Cash Outflows (LHS) Cum

TARP Cash FlowsIn Billions $

The Automotive Industry Financing Program providedapproximately $80bn in loans and equity investment.

In June, over $68bn was repaid to the Capital Purchase Program by JPMorgan, Morgan StanGoldman, US Bancorp, AMEX, BONY, BB&T, Capital One, State Street, and Northern Trust.

In March, the Term Asset -BackedLending Facility , a joint venture with the Federal Reserve, was launched.

On October 14, 2008, the Capital Purchase Program was launched. By January 1, 2009, over $247bn in funds had been disbursed to U.S. banks.
Cumulative Fiscal Budget Deficits Year-to-Date

7

$0

$200$400$600$800

$1,000$1,200$1,400$1,600

Oct-07

Nov-07

Dec-07

Jan-08

Feb-08

Mar-08

Apr-08

May-08

Jun-08

Jul-08

Aug-08

Sep-08

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

May-09

Jun-09

Jul-09

A09

In Billions $

FY2008 FY2009 FY2010
Primary Dealer and Government Deficit Estimates

8

FY 2010-2012 Deficit and Borrowing Estimates 

Primary

Dealers* CBO 

FY 2010 Deficit Estimate 1,380 1,349 FY 2011 Deficit Estimate 1,183 980 FY 2012 Deficit Estimate 991 650 

FY 2010 Deficit Range 1,200-1,600FY 2011 Deficit Range 1,000-1,396FY 2012 Deficit Range 800-1,200FY 2010 Marketable Borrowing Range 1,190-2,330FY 2011 Marketable Borrowing Range 900-1,990Estimates as of: Apr 2010 Jan 2010 *Based on Primary Dealer feedback on April 30, 2010. Deficit estimates a
AUCTION DEMAND

9
Auctions Have Exhibited Strong Coverage over the P

Auctions Have Exhibited Strong Coverage over the P

10

$0

$200$400$600$800

$1,000$1,200$1,400$1,600$1,800$2,000

FY2000 FY2001 FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 F

Weighted Average Coverage Ratio on Notes and Bonds In Billions $, Coverage Ratio

Gross Issuance (LHS) Weighted Average Coverage R

Note: Excludes TIPS and Bills issuance.
Auctions Have Exhibited Strong Coverage over the P

age over the P

11

1.001.502.002.503.003.504.00

$15 $20 $25 $30 $35 

Offering Amount

Coverage Ratios: 2-Year Securities FY2008-FY2010Coverage Ratio by Offering Amount in Billions $

Most Recent Auction: 4/27/2010

Bid-to-Cover Ratio

1.001.502.002.503.003.50

$20 $22 $24 $26 $28 

Offering Amount

Coverage Ratios: 7-Year Securities FY2009-FY2010Coverage Ratio by Offering Amount in Billions $

Most Recent Auction: 4/29/2010

Bid-to-Cover Ratio
PORTFOLIO METRICS UPDAT

12
13

Bills and Nominal Coupons Trending Back to Norma

20%25%30%35%40%

Jan-00

May-00

Sep-00

Jan-01

May-01

Sep-01

Jan-02

May-02

Sep-02

Jan-03

May-03

Sep-03

Jan-04

May-04

Sep-04

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Jan-07

BillsPercentage of Total Portfolio 

Average 2000-July 2007

Ex-SFversu

50%55%60%65%70%75%80%

Jan-00

May-00

Sep-00

Jan-01

May-01

Sep-01

Jan-02

May-02

Sep-02

Jan-03

May-03

Sep-03

Jan-04

May-04

Sep-04

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Jan-07

Nominal CouponsPercentage of Total Portfolio

Average 2000-July 2007
TIPS Issuance Will Continue to Increase

14

$0

$10$20$30$40$50$60$70$80

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 20

TIPSCalendar Year Issuance in Billions $, Percent of Portfolio

30‐Year (LHS) 20‐Year (LHS) 10‐Year (LHS) 5‐Year (LHS) TI

Note: The 20-Year TIPS was suspended in November 2009 in favor of a 30-Year offering.
Average Maturity of the Debt Continues to Lengthen

15

2030405060708090

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Average Maturity of Marketable Debt Outstanding Average Maturity of Issuance (4Q Moving A

Note: From February 2002 toJanuary 2006, the 30-YearBond auctions were discontinued.

Average Maturity and Issuance of Marketable Debt OutstandMaturity in Months, Fiscal Year 
Percentage of Debt Maturing in the Near-Term is at H

e Near-Term is at H

16

20%25%30%35%40%45%50%55%60%65%70%75%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 

Percentage of Debt Maturing in Next 12 to 36 MonthsFiscal Year

Maturing in 12 Months Maturing in 24 Months Maturing in 36 

The percentage of debt maturing in 12, 24 and 36 months 

is lower than it has been in over 25 years.
LONG-TERM CHALLENGES

17
OMB Long-Term Debt Metrics

18

$0

$100$200$300$400$500$600$700$800

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

Interest ExpenseIn Billions $, Percentage of GDP

Interest Expense (LHS) Interest Expense as a 

Note: Interest costs based on interest on Treasury debt minus interest on trust funds and other income.

$0$5

$10$15$20$25$30

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Outstanding Debt In Trillions $, Percentage of GDP

Held by Public (LHS) Held by Government Accounts (LHS) Public As a % of GDP (RHS) Gross As a % of GDP (RHS)
Long-Term Deficits and Healthcare Reform

19

-$20

$0

$20$40$60$80

$100$120$140$160

2010 2011 2012 2013 2014 2015 2016 

Cumulative Reduction In Deficit From Health Care ReformIn Billions $

Source: CBONote: Deficit impact based on CBO deficit estimates.

-$1,800-$1,600-$1,400-$1,200-$1,000

-$800-$600-$400-$200

$0

$200$400

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

Budget Surplus/DeficitIn Billions $, Percentage of GDP

Surplus/Deficit $ (LHS) Surplus/Deficit Percenta
20 

What adjustments to debt issuance, if any, should Treasconsideration of its financing needs in the short, medium

In Billions $ Less Equals 

Current Issuance Path1 Coupon Maturities2 Net Cash Raised 

Is

FY2010 2,285 626 1,659 

FY2011 2,400 709 1,691 

1Gross issuance values for Coupons and net issuance values for Bills. Issuance sizes for Nominal and TIPS 

assumed to remain at March 31, 2010 level (without SFP).

2SOMA is assumed to rollover its holdings.3Projected net financing needs for FY2010 match the May 2010 Office of Fiscal Projections borrowing estima

marketable borrowing figure from OMB’s FY2011 Budget.

Projected Borrowing Needs Imply Treasury Needs to Reduc
Treasury Borrowing Advisory Com

Presentation to Treasury

Charge #2

May 4, 2010
1

The Charge

Given the recent focus on global sovereign credit risk by market participants, wCommittee to comment on the use of sovereign credit default swaps (CDS). Plthe characteristics of the sovereign CDS market, including the liquidity of the prparticipants, and the factors driving spreads. What are the implications for Treasovereign issuers more generally?
Table of Contents

I. Overview of Sovereign Credit Default SwapsII. What is the Size of the Sovereign CDS Market?III. What is the Liquidity of the Sovereign CDS Market?

IV. Who are the Major Market Participants?V. How are Investors Positioned?VI. What are the Drivers of CDS Spreads?VII. Do Sovereign CDS Spreads Drive Cash Spreads Wider?VIII. Greece: Interaction between Cash and CDS MarketsIX. Benefits and Risks of Sovereign CDSX. What are the Implications for Sovereign Issuers?XI. What are the Implications for the U.S. Treasury?XII. RecommendationsXIII. Appendix

3 4 – 678910 – 1213141516171819 - 24

2
3

Overview of Sovereign Credit Default Swaps

Characteristic DescriptionReference Entity  May be a single name (e.g. Greece) or an index (e.g. 

Europe)

Western European countries are most commonly trade

PIIGS (Portugal, Ireland, Italy, Greece, and Spain)

Maturity  5-year is most common (estimated to account for ~70% 

The 10-year tenor is the second most active maturityBank counterparty desks sometimes seek shorter mat

liquidity is thin

Spread Quoted on an annual basis but payments are made qua

Contractual Foundation Terms between counterparties are dictated by ISDA agrStandard Credit Events Failure to Pay, Restructuring, and Repudiation/Morato

A voluntary bond exchange would not necessarily trigg

Currency While CDS on many European sovereigns is quoted in 

Euros, the vast majority of trades (estimated at over 85%Dollars

Reporting DTCC began publishing statistics on positions starting iRecent Changes to CDS Markets in U.S. Coupon and maturity standardization (April 2009) mak

positions and create operational efficiencies

 Move toward central clearing facilitates netting, increa

provides more information for regulators

Potential next step is moving toward exchanges (from 

Source: Sovereign CDS market makers
What is the Size of the Sovereign CDS Market?

4

As of April 23, 2010, there was approximately $230 billion of sovereign CDS net notional an$2.3 trillion gross notional outstanding. While the media frequently focuses on the gross noutstanding, net notional is a more appropriate measure.

 Gross Notional Outstanding = Total notional of all trades outstanding  Net Notional Outstanding = Maximum amount of money that would change hands if 

entity defaults

As sovereign risk has garnered more attention over the past year, the market has grown ra

Growth of Net and Gross Notional Outstanding for Sovereign CDS

Note: Notional amounts listed above include both single-name and index CDS on sovereigns Source: Barclays Capital, DTCC
What is the Size of the Sovereign CDS Market? (

Despite its recent growth, the sovereign CDS market is small relative to the corporate CDS marke

 The corporate CDS market is over eight times as large as the sovereign CDS market on a 

 The corporate CDS market has over 1000 reference entities, while the sovereign market h

However, sovereigns represent 13 of the top 20 single-name reference entities as measured by n

Net and Gross Notional Outstanding as of 4/23/2010 ($bn) Net Notional Outstanding as of 

5

Source: J.P. Morgan, DTCC 
What is the Size of the Sovereign CDS Market? (

6

CDS Net Notional Outstanding as Percentage of Central Government Debt (for countries with 10 largest ne

Today, sovereign CDS markets are a fraction of the size of the sovereign cash markets

 The opposite is true for many corporate issuers (i.e. net notional of CDS is larger th

outstanding)

This fact may limit the impact that the sovereign CDS markets can have on cash bond yield

Note: CDS Net Notional Outstanding is as of April 23, 2010. Government debt outstanding is based on the most recently available figures.Source: International Monetary Fund, Bloomberg, government websites 
What is the Liquidity of the Sovereign CDS Marke

7

Estimated Monthly Trading Activity in Single-Name Western European Sovereign CDS, inc

Average monthly trading volume over the past year for single-name Western European sovactive sector of the market) is conservatively estimated to be $34 billion*While liquidity varies by reference entity, trades of $25 to $50 million notional are commonBid-ask spreads for tighter sovereigns (e.g. Germany, United Kingdom) are typically less thbut the bid-ask spread for Greece CDS was recently as wide as 100 basis points

*Monthly trading volumes are estimated by Barclays Capital. According to Barclays, these estimates likely understate actual trading volumes with their own flows. Although the DTCC publishes some information on trading activity for each reference entity, that data likely overestimatetrade compressions and trades re-booked through a central clearinghouse are included. Source: Barclays Capital, Citigroup Global Markets, Goldman Sachs
Who are the Major Market Participants?

8

Relative Market Share Estimates*

Natural Buyers Buyer & Sellers Natural SellersBank Counterparty Hedging Desks: 

Purchase CDS to hedge government exposure that results from mark-tomarket derivative exposures (e.g. fixed-floating swaps)

 In many cases, hedging is driven by 

regulatory constraints, which results in price insensitivity

Hedging via CDS is essential because 

sovereigns have historically been considered risk-free and have never been required to post collateral to counterparties

Hedge Funds & Prop Trading Desks: 

Macro-driven, inter-region relative value, and basis trades

Real Money Investors: Hedge cash 

bond positions, use as cash bond substitutes, put on directional, basis,and relative value trades

Emerging Markets Funds: Increasingly 

active in directional and relative value trades given recent widening in European sovereign spreads

Not clearThe lack of natur

CDS has been olimited liquidity orelative to sovere

 Prior to the credit crisis, bank c

hedging desks played a much sthe sovereign CDS market

* The DTCC does not report trad

this level of detail. Market share based on discussions with sovemarket makers. Source: Barclays Capital, Citigroup Global Markets, discussions with sovereign CDS market makers

Real Money 

Managers, 20%

Hedge Funds, 30%

Counterparty Risk 

Desks, 50%
9

How are Investors Positioned?

Investor positioning in sovereign CDS has shifted over the past 18 months from a net shorlong positionDuring this period, net notional outstanding has increased markedlyThe wider spreads in recent month likely attracted more investors willing to sell protectionposition in sovereign credits

Investor (non-dealer) positioning and total net notional outstanding for single-name sovereig

*This chart shows aggregate investor positioning across all sovereigns. DTCC does not provide data to view positioning on single countries, Source: Barclays Capital, DTCC, sovereign CDS market makers
What are the Drivers of CDS Spreads?

10

 CDS spreads are an indicator of default risk, which is driven by a range of macroe

such as the current account balance, fiscal balance, debt/GDP, liquidity, refinancinstability and credibility of government policies

 A recent study by the IMF found current account balance, required fiscal adjustme

border bank claims on the public sector to be correlated with CDS spreads

 Credit ratings (which incorporate macroeconomic and other indicators) bear some 

spreads, but are not continuously adjusted and can be a lagging indicator of defau

IMF Decomposition of 5 Year CDS Spreads (as of Spring 2010) Western Europe CDS Spreads vs. S&

1. Macro Fundamentals

Source: International Monetary Fund, Standard & Poor’s
What are the Drivers of CDS Spreads? (continued)

11

2. Market Sentiment / Risk Tolerance

 CDS spreads tend to widen and 

narrow in tandem with other risky assets

 The graph shows the strong 

relationship between the average CDS spread of the PIIGS countries and the S&P 500 (as equities fall, CDS spreads widen)

 The relatively high correlations among 

the PIIGS further illustrate that market sentiment is a driver of CDS spreads

3. Counterparty Risk

 CDS spreads may widen as 

counterparty risk increases

 Mitigated by central clearing, 

collateral posting and the potential move to exchanges

4. Currency Risk

 CDS spreads can vary depending on the currency of denomination Given the belief that the Euro will weaken if a European sovereign defaults, investo

to pay a premium for USD-denominated CDS

 For example, USD-denominated CDS on Greece trades ~40bps wider than EUR-de

CDS

 CDS on European sovereigns is predominantly denominated in US Dollars (85% or 

Source: Bloomberg, J.P. Morgan, Citigroup Global Markets, sovereign CDS market makers

Correlation of Weekly Spread Changes (Jan 
What are the Drivers of CDS Spreads? (continued)

Status of Basis

CDS vs Cash Trade to 

Perform

TheoreticalImpact on Cash Bonds

Practical Considera

Positive Basis CDS wider than 

cash

Sell CDS ProtectionShort Cash Bonds

Wider Hard to short 

thus traded i

Negative Basis

Cash wider than CDS

Buy CDS ProtectionBuy Cash Bonds

Tighter Trades typica

only if basis (e.g. 100bps

12

5. Cash/CDS Basis

 The basis refers to the difference between CDS spreads and cash spreads Many factors contribute to the basis including differences in maturity, liquidity, fund

preferences, expectations about restructuring format (e.g. bond exchange), and m

 Bond market participants sometimes put on “basis trades” to try and arbitrage the 

 According to market makers, few investors are putting on sovereign CDS basis tra

directional and relative value trades more common), thus the basis is not currently sovereign CDS spreads 

 Basis trades are unlikely to drive cash spreads wider because the CDS market is s

cash market and, practically speaking, it is hard to short cash bonds

Source: J.P. Morgan, Barclays Capital, sovereign CDS market makers
Do Sovereign CDS Spreads Drive Cash Spreads 

13

 Bill Lockyer, California State Treasurer, recently concluded that CDS is not affecting 

funding costs

– As of April 23, 2010, the net notional amount of outstanding California CDS w

$1 billion, which is less than 1.5% of the State’s outstanding general obligation 

Correlations of weekly spread changes from January 2009 to present*

*Spreads are computed versus German Bunds. Correlations higher than 26% or lower than -26% are statistically significant at the 5% level

Source: International Monetary Fund, State of California, J.P. Morgan, DTCC

There is no evidence that sovereign CDS is driving cash spreads and borrowinsovereigns higher

 A recent study by the IMF concluded that Greek CDS spreads are not a leading indi

coincident indicator

 PIIGS CDS and cash spreads are highly correlated

– This is consistent with work done by J.P. Morgan and Barclays Capital on var
14

Greece: Interaction between Cash and CDS Mar

Historical Cash and CDS Spreads for Greece (bps) Net and Gross Notional Ou

The net notional outstanding of Greece CDS contracts has increased only 10% beginning of 2009. As of April 23, 2010, the net notional outstanding was $8.2 bless than 2% of outstanding Greece debt.There is no statistical evidence that Greek CDS spreads lead cash spreadsFurthermore, CDS spreads were not more volatile than cash spreads during tha

Cash and CDS spreads updated as of April 29, 2010Source: Barclays Capital, J.P. Morgan, DTCC
15

Benefits and Risks of Sovereign CDS

Benefits of Sovereign CDS  Risk management tool for wide range of participants Efficient, low-cost way to gain or reduce exposure to a given sovereign or index Allows the market to ‘short’ more efficiently, because shorting cash bonds can be difficult  Improves the price discovery process and alerts the market to perceived risksRisks of Sovereign CDS  Defaults could lead to contagion if transparency on positions is low and/or counterparty ris

– Mitigated by recent moves to standardize contracts and implement central clearing

 Primary concern is that CDS spreads lead to unnecessarily higher funding costs for sover

issuers under a scenario such as the following:

– As spreads widen and become more volatile, the market may become skewed towa

who want to go short (i.e. buy CDS protection)

– This could lead to further volatility and CDS spread widening, which may ultimately 

into the cash bond market and lead to decreased liquidity and higher bond yields

– Thus far, there is no evidence that this risk is materializing
What are the Implications for Sovereign Issuers?

16

CDS spreads are a readily-available indicator of sovereign default risk that shou

monitored and used to inform policies and actions

 Sovereign issuers should take prompt and decisive action with regard to 

risk because it can quickly spill over into the financial/banking sector, credangerous spiral

 Widening of cash or CDS spreads is typically accompanied by increases 

wholesale funding costs and also leads to markdowns for banks that own portfolios of government bonds 

Unless CDS volumes increase dramatically relative to cash, CDS is unlikely to b

driver of funding costs for sovereigns

Continued regulation and efforts to improve transparency should reduce contag
CDS on the U.S. is not very actively traded and is viewed as somewhat theoretical

 Currency depreciation through an increase in the money supply is considered a more likely scena The financial meltdown that would likely accompany a U.S. default could make it unlikely that pro

banks) would remain able and willing to pay principal to protection buyers

As of April 23, 2010, the U.S. CDS market has $2.3 billion in net notional outstandingthan 0.03% of U.S. debt held by the public

 Net notional has been very stable in recent years Given the relatively small size of the CDS market, it is unlikely to have any significant implications 

However, there is potential for more volatility or widening of U.S. CDS spreads due to concerns such as: 

 Rising or unsustainable fiscal deficits  Increasing debt/GDP and/or cost of debt (higher interest rates) Rising or unsustainable current account deficit / inability to attract sufficient foreign capital Concerns about status of USD as reserve currency and/or currency depreciation Deflation or high inflation

What are the Implications for the U.S. Treasury?

Historical CDS Spreads on the United States (bps) Gross and Net Notional Outsta

Source: Barclays Capital, DTCC

17
18

Recommendations

Proposals to ban “naked shorts” should not be adopted

 The definition of “naked” is unclear, which could make regulation difficult

 No evidence that “naked” CDS is leading to higher funding costs Banning “naked” positions will likely reduce liquidity and limit price discovery Investors will likely find a way to circumvent the restrictions by selling or shorting ca

expressing their views through other markets (e.g. equities, currencies)

Regulators should focus on solutions that prevent contagion without reducing liquidity

 Continue efforts to implement central clearing and minimize counterparty risk Enhance required disclosure of holdings by banks and other financial institutions Require more consistent collateralization practices, including for sovereigns

 Strengthen operational infrastructure

Continue efforts to improve the amount and quality of data about sovereign CD

 The DTCC began publishing CDS market statistics in October 2008. These statistic

improved from what was being reported previously but still have several shortcomin

 The DTCC does not capture 100% of market positions There is no “clean” way to view trading volumes Data is aggregated across maturities  Trades involving different desks within the same counterparty are not reflected in ne

because net notional is defined as net buying/selling of protection between counterp

 Several reports exclude reference entities with less than 50 transactions in the last w
19

Appendix
20

Overview of Sovereign CDS Indices

CDS indices are contracts that reference a standardized portfolio of entitiesingle entityThe main sovereign CDS indices are:

 CDX EM SovX Western Europe SovX CEEMEA SovX Asia Pacific, which will start trading on May 4, 2010

Trading applications of sovereign CDS indices:

 Hedging regional risk Relative value – either index vs single-name or index vs a different index Liquidity – lower bid-offer than certain single-name CDS entities

Potential implications of sovereign CDS indices:

 Increased correlation between constituents of the same index Increased correlation between regions because investors may express macro views 

As of April 23, 2010, the net notional outstanding of sovereign CDS indices was ~$205 billion for single-name sovereign CDS

Source: Barclays Capital, DTCC
Pros

 More pricing transparency may lower bid-ask spreads Lower systemic risk  Less counterparty risk May increase liquidity as new participants enter the market (i.e. those concerned a Higher collateral requirements and guarantee funds mitigate gap risk

Cons

 Increased transparency may disadvantage dealers as bid-ask spreads may narrow 

 If the market becomes sufficiently unattractive for dealers, they may not support the 

liquidity

 Potential for higher costs due to stricter margin and collateral requirements, transac

and contributions to guarantee funds at the clearing houses (could be offset by lowe

 Makes sense only for more standardized derivatives so not everything will be cove The failure of the exchange would likely lead to a crisis

21

Pros/Cons of Moving CDS to an Exchange
22

Publicly Available Information from the DTCC

Section 1: Data on all live positions in the Trade Information Warehouse

Aggregate Gross and Net Notional and Number of Contracts for:All Credit ProductsTop 1000 Reference EntitiesAll Indices and Index TranchesGross Notional and Number of Contracts Broken out between Dealers and Non-dealers for:Single-Name Reference Entity Type (e.g. Sovereign, Financials) by Buyer of ProtectionSingle-Name Reference Entity Type by Seller of ProtectionOn-the-run/Off-the-run Index/Index Tranche by Buyer ofOn-the-run/Off-the-run Index/Index Tranche by Seller of ProtectionGross Notional & Number of Contracts for Aggregate Single-Name Contracts by Year of Scheduled Termination Date 

Section 2: Change in Weekly Activity for Trade Information Warehouse Positions

All Reference Entities Gross Notional, Net Notional and number of contracts All Indices and Index Tranches Gross Notional, Net Notional and number of contractsCredit Products by Customer Type and Breakout by Product Type – Dealers vs. Non-DealersGross Notional & Number of Contracts for Aggregate Single-Name Contracts by Year of Scheduled Termination DateGross Notional and Number of Contracts Broken out between Dealers and Non-dealers for: Single-Name Reference Entity Type (e.g. Sovereign, Financials) by Buyer of ProtectionSingle-Name Reference Entity Type by Seller of ProtectionOn-the-run/Off-the-run Index/Index Tranche by Buyer ofOn-the-run/Off-the-run Index/Index Tranche by Seller of Protection

Section 3: Weekly transaction activity in the Trade Information Warehouse

Summary of Weekly Transaction Activity – New Trades, Other Increase Activity, Terminations, Other Reduction Activity, Ass

New Trades, Full Assignments, Partial Assignments for:All Indices and Index Tranches by by Transaction Type with > 50 contracts (Position Increases)Single-Name Reference Entities with > 50 contracts (Position Increases)Single-Name Reference Entity Type (e.g. Sovereign, Financials) by Transaction Type (Position Increases)Partial Terminations Full Terminations, Exits for:All Indices and Index Tranches by Transaction Type with > 50 contracts (Position Reduced)Single-Name Reference Entities with > 50 contracts (Position Reduced)Single-Name Reference Entity Type (e.g. Sovereign, Financials) by Transaction Type (Position Reduced)

The following data are available from the Depository Trust & Clearing Corporation (DTCC) 
Credit Events for Sovereign CDS

 Contract is triggered on the CDS when a credit event occurs on an obligation Any debt explicitly guaranteed by a sovereign can trigger a default of that sovereign Standard ISDA defined credit events for sovereign CDS

– Failure to pay– Restructuring (may be triggered by a change in currency, if the bonds were no

domestic law) 

– Repudiation/moratorium: authorised government authority (or reference entity

imposes moratorium and failure to pay or restructuring occurs. Generally only reference entities

– Obligation acceleration: one or more obligations due and payable as a result 

a default or other conditions or events described, other than a failure to make payment. Generally only used for emerging market reference entities

 “Deliverable obligations” limit which obligations can be delivered upon a credit event

– Deliverable obligations are limited to government-level debt,...– ...even if the failure of other sovereign-guaranteed debt triggered the default

 Obligations are typically limited to borrowed money

– Bonds/loans– Not derivative contracts or trade receivables

23

Source: J.P. Morgan
Cash Settlement of CDS Following an Event of D

Relevance of CDS Auctions to Cash Bonds

 At present, the net notional outstanding of sovereign contracts is very small compared to the amount of 

outstanding. As a result, cash settlement for sovereign CDS contracts is not particularly relevant at the 

 However, if the sovereign CDS market were to become large relative to the cash market, CDS settleme

on cash bonds and therefore alter bond yields

Auction Mechanics

 In an event of default, the standard CDS contract calls for physical settlement of the underlying contrac

delivers the notional worth of bonds to the seller of protection in exchange for the par amount. Cash setnot market standard.

 Given the large amount of CDS positions outstanding, the ISDA auction protocol has been developed a

cash settling CDS contracts. The auction process aims to facilitate cash settlement and preserve the ec

settlement, by enabling investors to settle all contracts at the same recovery rate.

 The auction mechanism is a two-step process. Marketmakers submit a bid and offer price for the bonds 

These levels are not traded in the first step of the auction, but may be in the second step. 

 The auction administrator will then order the bids they receive from the highest to lowest and the offers 

highest. Any market that crosses is deemed a tradable market and excluded from the price determinatiothen calculated using the best half of the remaining valid markets. The IMM (Inside Market Midpoint) is markets.

 At the same time that the marketmakers submit their bids and offers to determine the IMM, they also su

bonds that they wish to buy or sell in the form of Market Orders

 We now have the indicative price of the auction as well as the net open interests, both of which are pub

Market participants can now enter Limit Orders to hoover up the open interests.

24

Source: J.P. Morgan
Treasury Borrowing Advisory C

Presentation to Treasu

Charge #3

May 4, 2010
2

Treasury Borrowing Advisory Committee QuarCommittee Charge #3 – May 4, 2010“Since late 2008, interest-rate swap spreads relative to U.S. Treasuries substantially. In the recent weeks, the spread tightening has accelerateat times trading at negative levels. We would like the Committee’s viewcontributed to the persistent narrowing of swap spreads to Treasuries. 

for Treasury?”

-20

0

20406080

100120140

2000 2001 2002 2003 2004 2005 2006 2007 2008 

10y spread Fed Funds 4/30/2010 (at -2.2500

10-year swap spread (bps)

10yr spread

10yr swap spread (bps)
3

Supply and Demand Dynamics Can Be IndepeSwap Rate Curve and the Treasury CurveSwap Spread Drivers

• Supply of government debt• Balance sheet / funding and FRA-OIS• Corporate issuance hedging• Pension fund and insurance liability demand• Mortgage convexity hedging pre and post Fed mortg

program

• Declining use of derivatives• Artificial notion of the zero-barrier• Hedging of currency-linked and curve-linked notes• Quarter-end dynamics
4

Primary Drivers of Swap Spread Narrowing SiThe collapse in swap spreads since the fall of 2008 was likely factors that struck nearly simultaneously:

• 3m Libor/OIS hit its all-time peak of 361bps on October 10, 2008

collapse, before declining sharply and steadily from there. The re(thanks to Fed programs instituted at the time) was a major drivecompression and repair of spreads. In conjunction, 10yr swap sp75bp in late September and spreads have narrowed steadily sinc

• Treasury began to dramatically ratchet up supply (leading to the 

Effect" on spreads) in October and November of 2008 as well. UTreasury had been adding incrementally to coupon auction sizesTreasury surprised the market with a $40B "Tap" of 2015/18 issuRefunding the following month, Treasury brought back 3yr notes hiked 10yrs by $3B and 30yrs by $4B. Here began the RAPID risthat continued unabated for another year.
5

The Denominator: Supply

-20

0

20406080

100120140

1988 1990 1992 1994 1996 1998 2000 2002 2004 20

10y spread Budget Surplus (Deficit) as % of Nomina

R^2 = 43.74% (y~6.28x + 69.19)

10-year swap spread

10yr spread

10yr swap spread (bps)
6

The Numerator: Rapid Decline in Private SectoPublic Sector Debt

0

5,000

10,00015,00020,000

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 

Federal Government CorporateDomestic Financal Home Mortgage

Outstanding Debt in Billions (Z.1)

-50

0

50

100150200

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 

10y spread Corporate / Federal Debt Outstanding

10-year Swap Spread (bps)

10yr spread

10yr swap spread (bps)
7

Significant Supply Shock

Long term trends in swap spreads are highly correlated to changes in Treasury and Corporate Issu
8

Credit Risk Stays Correlated to 2yr Spreads, But DCaused a Collapse in 10yr Swap Spreads after Leh

0

50

100150200250300

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 

IG US 2y spread 10y spread

5-year Investment grade CDS (IG) (bps)

2y spread with IG R^2= 35.99%10y spread with IG R^2= 8.71%

US 2yr spread 10yr spread

5yr Investment grade CDS (IG) (bps)

2yr

10yr
9

-100

-50

0

50

100150

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Ja

US 30y spread JPY

R^2 = 79.16% (y~2.97x 

30-year swap spread (bps)

0

50

100150200

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Ja

US 2y spread FRA-OIS

R^2 = 68.47% (y~0.41x + 38.26)

2-year swap spread (bps)

US 2yr spread

30yr swap spread (bps) 2yr swap spread (bps) US 30yr spread

Swap Spreads in 2008 – Exotic Hedging Affecand Funding/Balance Sheet Pressures Influen
10

30yr Swap Spreads: Technical Not FundamImplied AA bank credit could not have been more valued than sovereigof the financial crisis

23456789

98 99 00 01 02 03 04 05 06 07 08 

30-year swap rate US 30y spread

R^2 = 77.63% (y~0.02x + 4.42)

30-year swap RATE (bpspread_rate_30s)

30yr swap RATE (bpspread_rate_30s)

30yr swap rate US 30yr spread
11

Bank CDS: No Correlation to 30yr Spread

-80-60-40-20

0

20406080

100

Jan-07 Jan-08 Jan-09 

US 30y spread 5-yr Bank CDS 5/3/2010 (at -22.9

R^2 = 57.37% (y~-0.46x + 64

30-year swap spread

30yr swap spread

US 30yr spread 5yr Bank CDS
12

Interest Rate Swaps Outstanding: Declining SinOutstanding Treasurys Rise
13

The Myth of the Zero Barrier? 

• Gilts broke through 0 before UST (30yr in ‘08 and 10yr in ‘09)• JGB asset swaps (not shown) broke through 0 in 2001• Long swap spreads have historically traded tighter in the U.K. and Germany primarily due to in• The theoretical positive arbitrage of inverted government asset-swap spreads is impractical du

-40

0

4080

120

Jan-07 Jan-08 Jan-09 

UST Gilt Bund

Swap - Government (bps) UST - Gilt R^2= 6

UST - Bund R^2= 

-100

-50

0

50

100

Jan-07 Jan-08 Jan-09 

UST Gilt Bund

30-year Government - spread (bps) Bond - Long Gilt R^2

Bond - Buxl R^2= 88.

30yr swap spread (bps) 10yr swap spread (bps)
14

Cause for March 2010 10yr swap spread Collapse

• The primary driver for the recent collapse in 10yr swap spreads was a tech

by quarter-end balance-sheet reduction pressure. Financial institutions paholdings, particularly U.S. Treasurys, and replaced duration with longer dadue to increasing downward pressure on leverage ratios.

• A rare string of weak Treasury coupon auctions in late March (that produc

highlighted the quarter-end pressures on the Treasury market, pressures wcollapse in swap spreads.

Swap Spreads Collapse into March 2010 Q

10yr swap spread (bps)

10yr spread
15

Sharp Decline in Bank Leverage

Source: 
16

Quarter-Ends: Impact on 2s10s and 10yr y

2.02.42.83.23.64.04.4

1-Jan-08 1-Jul-08 1-Jan-09 1-Jul-09 1-Jan-1

10-year UST yield 2s10s UST

10-year yield 10yr yield

10yr UST yield
17

Quarter End 5yr Auction Tails versus 6-Au

-3.00-2.00-1.00

0.001.002.003.004.005.006.00

Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 M

5yr Auction Tail 6mo Average 
18

Deal Flow: Corporate Pipelines and Deal-related Push Swap Spreads Lower in Late March

y = -0.0001x + 2.523

R2 = 0.2151

-12-10

-8-6-4-2

02468

- 10,000 2

Weekly Co

Swap Spread Change w/w (bps)
19

-150-100

-50

0

50

100150

2000 2001 2002 2003 2004 2005 2006 2007 20

Convexity Need (bps) 30y current-coupon ra

Convexity need (move in rate relative to MA in bps)

Convexity Hedging EpisodesConvexity need modeled as CC mortgage rate minus 90Highlighted episodes shown in more detail on following 

30yr current-coupon ra
20

Dynamics: Convexity Hedging

• Mortgage convexity needs typically correlate to swap spread moves i.e. hi

swap spreads and vice versa.

• This was exemplified in July 2003 when 10yr swap rates rose 130bps in o• In late March 2010, the correlation completely broke down when yields an

10yr swap spreads gapped to new lows.

3040506070

-80 -40 0 40 80 120

Conv exity Need (bps)

1Jan-25Mar25Mar-17Jun17Jun-8Sep8Sep-1Dec

R^2 = 51.54% (y ~0.11x + 41.58)

10-year swap spread (bps)

2003

0

20406080

100

-160 -120 -80 -40 0 

Conv ex ity Need (bps)

1Jan-27Mar27Mar-23Jun23Jun-17Sep17Sep-15Dec

R

10-year swap spread (bps)

Jan08-Dec08

0

1020304050

-40 -20 0 20 40 60 80 100

Conv exity Need (bps)

1Apr-23Apr23Apr-15May15May -8Jun8Jun-1Jul

R^2 = 74.47% (y ~0.20x + 16.74)

10-year s wap spread (bps )

Apr09-July 09

-10

-5

05

1015

-15 -10 -5 0 5 10 

Conv ex ity Need (bps)

1Jan-22Jan22J an-15Feb15Feb-9Mar9Mar-31Mar

R

10-year s wap spread (bps )

Jan10-Mar10

10yr swap spread (bps) 10yr swap spread (bps)

10yr swap spread (bps) 10yr swap spread (bps)
21

Swaption Skew: Risk Reversals Show a Shthe Convexity Profile of the Market

• Due to the change in composition of the largest mortgage holders (namely 

do not hedge negative convexity, bank dealers are now structurally long vochronically short.

• This long volatility profile forces bank dealers to delta hedge and receive s

swaps on a rally – exactly the opposite of historical convexity hedging dyn

(100)

(75)(50)(25)

-

255075

100125

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Premium (cents

)

2.503.003.504.004.505.005.506.006.507.00

Swap rate

5y10y +100/-100 5y10y sw ap

(100)

(75)(50)(25)

-

255075

100125

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Premium (cents

)

— 5y10y +10

5yr10yr +100/-100 — 5yr10yr swap — 5yr10yr +100/

Swap rate
22

5yr CDS on US Government Debt and 10yr SwaThere is only a loose correlation between US sovereign CDS a

-20

0

20406080

100 0

20406080100120

Jan07 Jan08 Jan09 Jan10

10-year swap spread US protection

R^2 = 48.65% (y~-0.76x + 60.52)

10-year swap spread

5-year US CDS - Inverted

-12

-8-4

048

1216 

1-Feb 1-

10-year swap 

R^2 = 31.64%(y~0.48x + -16.89

10-year swap spread

10yr swap spread

10yr swap spread 10yr swap s

10yr swap spread

5yr US CDS - Inverted
23

Structural Changes

Fiscal Shifts

• We may have seen the peak in Treasury coupon issuance.• Total Treasury funding is outpacing deficit estimates.• We expect significant coupon supply reductions going forward.• This will have a direct affect on swap spreads and normalize the 

Regulatory Changes

• Separation of banks from derivative dealers – Potential sharp ch

volumes, margin requirements.

• Clearing of virtually all swaps – subtle direct effects, centralizatio

and margin management, hedge treatments.

• Exchange pricing of swaps – difficult to handle customization and 

rate swap futures are illiquid.

• Affect on corporate liability hedging of fixed-rate bond issuance.

Treasury Pay Fixed on 30yr Swap Spreads?

In order to take advantage of the positive arbitrage and lower fundU.S. Treasury should pay fixed on 30yr swap spreads.