Duration Mismatch

All our times have come
Here, but now they're gone
--Blue Oyster Cult

Nice description of the problem of 'duration mismatch' that has been engineered by the manipulation of interest rates by central banks.

Duration mismatch means using short term debt to fund projects that mature over long time periods. Suppose that you wanted to buy a house and that you figure it will take you 30 years to pay it off. Instead of taking out a 30 year mortgage (which would correctly match the duration of you debt with the duration of your project), you decide to take out a one year loan to pay one year's worth of interest and principal. At the end of the first year, you will look for a new one year loan on new terms.

It takes no genius to understand the risks here. What if interest rates explode higher in the next 12 months? What if it is hard to find a loan at all?

As the author points out, borrowers may be willing to take this risk if they think that interest rates are in periods of secular decline. In such a situation,duration mismatch pays off for the borrower.

This is precisely what has been occuring for years now, as the Federal Reserve has been suppressing interest rates below free market values for about 30 years. Yes, 30 years.

Everyone has jumped on the duration mismatch train. Individuals, companies, governments. Indeed, the most serious duration mismatch in place currently is likely the fact that the US government has been borrowing in short term debt markets to fund long term liabilities in programs such as Social Security and Medicare. Currently, OMB estimates federal government interest expense at about $200 billion in 2012. Should interest rates reverse higher in secular fashion, then our interest expense could easily triple or more in just a year or so.

We're rolling the dice that the Fed can keep interest rates suppressed. If interest rates can't be held down, then duration mismatch will morph into the grim reaper.

no positions