This is a Re-Blog from http://technitrader.com/weekly-stock-discussions/martha-daily-blog
TechniTrader Market Blog by Martha Stokes CMT
Banks took the money they received from the asset purchase, aka Quantitative Easing by the Federal Reserve Bank, and used it not as it was intended, which was to help small businesses and individuals finance debt during a recession.
Instead banks and financial services organizations were selling bond funds to the Buy Side institutions and also selling Interest Rate Derivatives, the “insurance policy” for the low interest rate bonds in those funds.
This was the exact same scenario that caused the banking debacle of 2008, just a different investment and derivative instrument. Instead of REIT fund of funds, it was Bond Fund of Funds. Instead of Credit Default Swaps, it was Interest Rate Derivatives.
There is nothing wrong with the basic investment concept, it is the quantity of the derivatives that posed the risk. With Interest Rate Derivatives accounting for 82% of the derivatives sold, a bubble was forming.
If the Federal Reserve Bank raised interest rates even a small amount, then banks that sold Interest Rate Derivatives would have Buy Side Institutions redeeming those Derivatives.
The similarity is that when Subprime Mortgages started to default, the Buy Side Institutions that had purchased the Credit Default Swaps as insurance redeemed those, creating the implosion as the banks were unable to meet the obligation of such a massive redemption demand.
REIT investment collapsed and CDSs forced banks into default. A similar risk was developing in interest rate swaps IF the Federal Reserve Bank had raised interest rates even a slight amount. T-Bills were at near-zero interest rates and continue to remain low as the Fed is not raising rates, despite what the news media purports.
Low interest rates benefit big banks, financial services companies and boost their revenues and earnings. However, the Federal Reserve Bank will not be able to keep interest rates at this level forever.
Those who thought it could or should were not facing some critical realities about the importance of relative interest rates to the stock market and certain areas of the economy. Not all industries benefit from near-zero interest rates. Near-zero interest rates have actually hampered growth for many areas.
Historically low interest rates were touted as being beneficial to the stock market; however, historically the stock market and interest rates have been in sync. As the stock market rises, the Fed tends to raise interest rates in response, assuming they can control the stock market buyers. When the stock market falls, interest rates are lowered in an attempt to control stock market sellers, which doesn’t work either.
This time as the stock market rose, interest rates did not, which allowed for growth in the derivatives market.
The difference this time was that Interest Rate Derivatives were cleared due to new regulations in place which allowed for a full documentation of the risk factors within the bond and Interest rate derivatives market. Not all interest rate swaps are cleared, but more are than ever before.
The massive exodus out of Bond Funds and Bond Fund of Funds that started last year about this time has lowered