What is the credit swap market? : Interview with Greg Foss (All Interviews)

Greg Foss is a Canadian who spent 32 years trading credit both in Canada and the US. High yield credit (or Junk Bonds), which he focused on, trades mostly out of New York. He believes that credit markets are the most important markets in the world. Everyone focuses on equities, but the reality is credit markets are far bigger and more important.

Interview Date : 15th March 2021

Greg Foss (All Interviews)

What happens when credit markets get sick?

I’ve seen my share of credit calamities over time. Equity markets get destroyed when the credit markets get sick, which we have seen time and time again in various financial crises. You can see the warning signs come from the plumbing of the credit markets. Even if equity markets continue to flirt with new heights sometimes, the credit markets always provide preliminary warning signals.

What does the credit market compromise?

The credit market comprises everything from government borrowings to provincial or municipal and state borrowings all the way down to corporates, mortgage-backed securities, bank loans, etc. We typically start with government bond markets, and the US treasury typically is the base level borrower. They are called “the quintessential risk-free borrower” in the world on top of which all other rates are set.

How does the debt market grow?

Debt markets grow because there’s a demand for bonds from both pension funds and investors who want to place their investable assets into contractual obligations. There’s always supply and demand for credit that depends on the price typically set as the interest rate.

This interest rate is the contractual rate a borrower pays to the lender. The borrower could be the government, a corporation, etc., but the difference with the government is that they have a central bank behind them, thus government borrowing rates can be manipulated in the markets by the central bank. For example, the central bank can buy the bonds of the US treasury. This is a problem because it manipulates delays or it sets a false borrowing level for the risk-free rate of the US treasury. When that happens, it affects all sorts of different bond and equities markets, and even discount rates will be impacted on equities. It is central bank shenanigans.

What is the debt spiral?

A debt spiral happens when too much money is borrowed. There are three options that the government has in order to sustain the borrowing binge. First, they can raise taxes but that’s generally not a popular choice for the citizens. Second, they can reduce spending which is not a very popular choice amongst politicians, especially if they want to maintain their job for the next election term. And third, which is also always the easiest option, print money.

How have yields changed?

When I started my trading career in 1988, US treasury yields were 14%. At the time, the Chair of the Federal Reserve, Paul Volcker, was determined to stop inflation. The way that you stop inflation is by raising interest rates, so at one point, interest rates went as high as 18%. but when I started, it was down to 14%.

Over the next 30 years, from 1988 to 2020 interest rates for US treasuries went down to under 1%. They actually bottomed out at 60 basis points, which is 0.6%. That means the coupons on the bonds have decreased, yields that investors earn as an investor in the bond market have meaningfully decreased, and borrowers have absolutely benefited from lower interest rates. As a borrower, you like low-interest rates but not as the lender who’s the investor. If these lender retirees are counting on those savings accounts or on bond funds to produce an income, they’ve been hurt.

How do borrowers benefit when interest rates lower?

The person who invested at 14% would have had a 14% coupon. When the interest rates went down to 10%, the price of his bond increased because bond prices increase when interest rates decrease. Now, the value of that 14% coupon is much more attractive than the ones that are being issued at 10%. A bond is a contractual obligation of a future series of cash flows. There are a lot of people saying “I get capital gains in bonds” but that’s a misperception. You don’t actually get capital gains, rather when you cash your 14% coupons at a present value,  it’s above your 100 cents on the dollar that you initially bought the bond at. So, all you’re doing is pulling forward your cash flows.

If you have to reinvest that cash flow today, you don’t do it at 14% but at a lower rate. Thus, over the years people who have said “I got capital gains in bonds”, it’s just because rates were going down.

What if interest rates start going up?

We actually saw interest rates go up in 2021. The 30-year treasury in the US was borrowing at a 1.25% coupon. In 2020, that 30-year bond interest rate increased equivalent to 2.72%, meaning that the bond that was issued in 2020 is more than 100 basis points lower than the 2021 interest rate. The people who experienced that lost 25% of their value in only 1 year. For many, it is hard to imagine but there is not 0 chance that the US treasury will default.

Now, if you’ve lost 25 % of your principal, it will take you 18 years of coupons to make back that 25% loss. This is all bond math that can be very painful called duration and convexity; a is a contractual obligation of price changes because the interest rates (the coupons) do not change as coupons are fixed over the period of the bond.

Who changes the rates of these coupons?

The market changes interest rates. The US Treasury auctions 30-year bonds regularly, and the coupons are set by the prevailing interest rate in the market at that time. So, everyone would love to have higher coupons if you’re investing, but the treasury will not give you higher coupons because the market is only charging the treasury a certain amount. And, that is how they decide on an interest rate for a particular point in time.

Why do people want to be in bond markets?

Because they can’t be 100% in equity markets. Typically, investment advisers have a 60-40 model portfolio where 60% is in equities and 40% is in bonds. Those 40% bonds could be government bonds, provincial bonds, state bonds, corporate bonds, and high yield bonds. Even “high yield bonds” only yield 4% today- it is ridiculous! In my history of treating high yield, that’s not high yield. You are almost guaranteed to lose money after defaults because high yield credits have a higher rate of default as they are riskier.

Can governments default?

Governments can default as well, and this leads to collateral damage. The myth that governments never default because they print money is not true. Historically we have seen governments like Venezuela and Argentina default. When I started in the bond market, Brazil and Mexico defaulted. I had to work on a project because treasury secretary, Nicholas Brady, designed a plan to restructure the debts which banks loaned to third-world countries, like Brazil and Mexico.

It’s really fun to borrow money when people are giving it to you because you can do projects, create jobs, create a federal stimulus, etc., but when you can’t pay that money back, it’s a hardship. When a country defaults, education and health care will be on the line for the citizens. Government defaults are rarely seen in G7 nations, but there are so many other countries where a government default is a regular occurrence.

What is the credit swap market?

The credit default swap market is default insurance on any reference asset. It is like an insurance policy that you purchase to protect yourself if the reference asset defaults. Purchasing the insurance costs you a certain premium each year, much like an insurance premium for house insurance, fire insurance, etc. There’s default insurance where you pay a certain premium that is set by the market and by the riskiness of the borrower. For example, Canada is a sovereign borrower and the insurance market for Canada is charging 37 basis points per year over a 5-year term to ensure Canada against default. This means the purchaser has to pay $37000 a year to ensure about $10 million worth of debt. The seller of the insurance collects the premium; however, they are on the hook for any payout in the event of default.

Now, that doesn’t sound like a big price tag for a country, but Canada is supposed to be a very high-rated credit, yet the market is signaling the opposite because the purchaser of insurance in Canada still has to pay $37000 a year. Imagine that the seller of the insurance is a big hedge fund or some counterparty that uses, let’s say, 5 times leverage. They can turn that 37 basis points into almost a 2% yield or return if they use 5 times leverage. Sounds like free money to some people, but the reality is in 2006, Lehman’s brother’s credit default protection was trading at 9 basis points, so  $9000 to insure $10 million of Lehman brothers debt. 3 years later that $9000 premium was worth $6 million because Lehman defaulted. Rates of insurance continued to increase, and it was like a spread that perceived credit quality of the reference asset changes. This meant that as it got riskier, the insurance market would charge more and more.

How are foreign investors at risk?

Let’s say you’re a foreign lender to Canada, and you own a ton of dollar debt (Canadian counterparty debt). When you realize that you own too much of that debt in Canadian dollars, you would want to purchase protection to reduce your exposure. In the market, you can purchase default protection from a seller of protection; it could be a big global investment bank, like Goldman Sachs, etc., which are all huge players in the market. This is how markets develop and calibrate risk premiums.

Such situations are created due to questioning confidence and trust in the borrower. Trust is a tough word – it’s not about trust but about managing risk. The average citizens may think politicians want well for their citizens, so they’re just borrowing as much money as they can. But as a lender, it increases my risk to that country. If they just want to turn on the tap and keep borrowing, implicitly that means they become a riskier credit.

What is a credit spread?

A credit spread is a function of the risk of reference asset failure, so the market charges you a higher premium. If you think of the US treasuries being the quintessential risk-free borrower over terms of T-bills to 5-year notes, 5-year bonds, 10-year bonds to 30-year bonds, etc., setting what’s called the risk-free rate will make everything else stack up on top of that.

Let’s look at a state or municipality within the United States, such as that state of Illinois is in big trouble. Their finances are horrible, so their premium that they have to pay over the US treasury is meaningful because there is a much higher level of risk of default in their case.

What is the defective too-big-too-fail concept of banks?

I started my career by working at the largest financial institution in Canada, and the reality was Royal Bank of Canada was insolvent in 1988. If you had taken its debts that they had lent to third world countries like Brazil, Mexico, Vietnam, Thailand, etc., cumulative losses the Royal Bank of Canada would have to absorb by writing down these loans would have exceeded the value with its book value of equity. Now, it was a scary thing because that is Canada’s largest financial institution. At the same time, it was no different from the money center banks in New York City. That is why treasury secretary Nicholas Brady had to come up with the Brady Plan.

You quickly realize that there is a de facto too-big-to-fail concept amongst global banks. Investors in the banks, including depositors that have deposit insurance provided by the country, think banks are too big to fail because it has an implied backstop. That implied backstop is the government providing protection through printing money. This whole fiat situation is suspect and it has been for a very long time.

How did you encounter Bitcoin?

I was asked to be an early investor in a company in Canada that wanted to bring Bitcoin to an exchange-listed fund in Canada. I helped to recruit the CIO. We took the Ontario securities commission to court to win the right to list a closed-end Bitcoin fund on the Toronto stock exchange. I was introduced to Bitcoin before I invested in that company, and as an engineer, I was convinced pretty quickly. I was shown Tradeblock.com which was essentially the blockchain-in-action. I saw the blocks that were being formed every 10 minutes, the mempool, the transactions flashing across the screen around the globe. The engineer in me was completely amazed at it.

I’ve never seen something so technologically beautiful in my life. Most importantly, it’s math and code, and there’s only 21 million Bitcoin, so there’s scarcity. It is a proven protocol that is open source. For me, it ticked all the boxes, and it’s everything I was looking for.

It took us about 4 years to win the battle against the Ontario securities commission. Canada launched 2 new ETFs, actual exchange-traded funds, which have now exceeded $1 billion invested in the Canadian market to have exposure to Bitcoin. Today, Canada has one of the most developed Bitcoin exchange-traded funds and communities in the world. It’s beautiful because it’s hedging the risks of what I term the fiat shenanigans.

What is Bitcoin to you?

Michael Saylor said it most perfectly; Bitcoin is digital energy. Let’s think about Saudi Arabia and Russia, for example. Do they really want to be selling their valuable natural resources for US fiat that continuously loses its value over time? Some might say, that’s why they are collecting and buying gold but that is not the answer. Gold 2.0 has already come out, and that already led back to Bitcoin. Gold has its problems as it does not have a fixed supply. Even if it grows about 2% a year, considering how much gold is in seawater, imagine if we technologically figured out how to remove gold from seawater; that would be the end-game for gold. Bitcoin has so many properties that gold doesn’t have like transferability, portability, divisibility, etc. As soon as the energy markets begin to be priced in Bitcoin, eventually with a high probability, Bitcoin will replace the US dollar as the world’s reserve asset.

Should the government impose regulation for a solution?

The best solutions tend to happen when it’s not government imposed. That’s what Bitcoin and the Bitcoin communities are doing. It is advancing intellectual awareness about fiat currency being dependent on complacency. It also relies on a status quo bias where people say “it’s worked up until now, so it will continue to work in the future”. Most importantly, it relies on intellectual laziness that requires people to believe and not do any digging below the surface of what a currency actually is. So, when I try to sell people on Bitcoin, I start by exposing the problems with fiat, and the fiat currency Ponzi-scheme.

Fiat relies on a continual appreciation of collateral, but the money loses value over time. This means that the value of your work, effort, energy, and time gets devalued into the future. You need an alternative, and it’s called Bitcoin. The common man can buy default insurance in the form of Bitcoin.

Should we be anti-government or anti-taxation?

That’s a difficult question. I’m a social welfare liberal but a fiscal conservative. I have a heart and I understand that it’s tough on many families, but math is math and there are always costs and benefits. As Margaret Thatcher said, “capitalism is the worst form of government except for all the other forms.” So, I’m a pure capitalist and think that communism only works until you run out of other people’s money. I believe in government for the people and taxation, but when it goes out of control, you need to find alternatives. Bitcoin is my alternative insurance against central bank shenanigans and politicians that don’t understand mathematics.

Why did the financial crisis in 2008 happen in the first place?

In 2008-2009, all the leverage in the financial system was transferred from the balance sheets of the banks to the federal government’s. It was a transfer of risk with no other choice because the Lehman brothers failed. And, if the other big financial institutions in New York, like AIG we’re allowed to fail, it would have brought down all the other investment banks and the world would have unwound.

What is our fiat currency based on?

It’s based on a fiat standard that requires a continual increase in the value of collateral in the loan. So, things like real estate have to increase and that is dangerous but it is what it is because banks are some of the most highly leveraged institutions. Their book value of equity is leveraged 25 times to their loans. So, if a loan loses 4%~5% of its value, the equity is vaporized. This is how the banking system works. Thank goodness for Satoshi in designing the most beautiful solution of math and code; Bitcoin. It is a decentralized, distributed beautiful ledger based on beautiful technology. It is anti-fiat.

What do you think of Jeff Booth’s statement “governments are trapped”?

Jeff and I are on exactly the same page. The bond and equity markets are only math, and if you understand math, you realize they are trapped. To reiterate, “The Price of Tomorrow” written by Jeff Booth is one of the best books if not the best book I’ve ever read. The man is brilliant, and I have talked to him on a personal basis once or twice. He is extremely motivated to help educate the world, and I’m honored to call him a compatriot. We believe in the simple mathematics of the markets.

How many countries in the world are going to default and what country will be the last one?

There are 188 fiat countries in the world. Almost all of them will fail before any G20 country fails. Within the G20 countries, the US dollar will be the last one to fail. In the smaller economies, and in some cases it’s that despotic leadership or criminal undertakings by various parties, etc., that come into play. Many of them are serial defaulters meaning that many are countries that have defaulted less than 20 years ago. They come back to the markets, the markets lend them more money, and they default again.

How concerning is the situation for G20 countries?

I’m very concerned about Canada as it does not have something like a European Central Bank backing. Even countries like Italy or Portugal, which have worse finances than Canada, are in better shape than Canada because they have a much stronger backing of the European central bank.

For Canada on a standalone basis, the market is telling us that it is not looking good, meaning that the 37 basis points I referenced before are a high rate for a triple-A-rated country. The market’s charging Canada single-A rates even though it’s got a triple-A credit rating. We know that the markets are typically far in advance of the rating agencies in terms of evaluating true credit quality. So, I’m not going to say which country will be first to default, but I’ll just say, right now Canada better smarten-up and start fessing up to the reality; that we printed more money and took on more debt per capita than anybody else in the world in the last 12 months.

During the Corona pandemic, was Canada the country printing the most?

Within the last 12 months, Canada has taken the awful leadership away from every other country in printing. Comparing it to Japan, Japan is a much bigger economy than Canada. So, there are always different considerations in terms of evaluating credit quality. Thus, the size of the economy is going to be a very important component. Canada, after all, only has an economy the size of California. We’re a beautiful country snaking along the US border, natural resource-heavy with generous social programs that perhaps we can’t afford if we do the math.

The credit markets are giving warning signals, but our politicians have no clue and still think “we have a free pass, and we will just be able to print our way to prosperity”.

How do you think Canada should pull up their socks?

Mathematically, it’s going to be very difficult. After years of the same patterns with printing and being backed by the government, we get used to it. Free money is like an addiction. If you tell people that you can have free money, and then you stop giving them free money, it will be very difficult to get off that addiction.

You might try to countermeasure through raising taxes, but perhaps we’re already at a level of diminishing marginal returns. This means that if we raise taxes, some of the economies will go underground to the black market, and it will be off-record so they’re not taxed.

Or, we can cut deficit spending, meaning we can try and balance the budget. However,  that in itself is painful, particularly when you’ve promised social programs to the people.

The third option is you print more money but that just makes the debt spiral turn into a death spiral. It is almost a certainty that the Canadian dollar will continue to be debased. The question is how painful it is for our future generations, and for our kids.

Interviewer , Editor : Lina Kamada


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