Negative Swap Spreads and Charlie Sheen

When Swap Spreads went negative, we tried to explain the situation. Once More Unto The Breach...

Try this, Dealer capacity determines the nature of those spreads.  I'm a dealer, I have a balance sheet. If my balance sheet position will not accommodate a certain type of corporate issuance swap spread, (which transform variable promised future streams into present fixed income streams based upon that corporate bond and its promise)  i.e. I don't have the collateral and/or don't want to take the risk, I simply refuse to make any of those transactions. Unless the price I receive is worth my risk.

How did the spread go to zero and negative? The dealer balance sheet capacity or offered money dealing for those kinds of swaps shrunk to nothing.  Why? One reason, the paper could be perceived to have HIV like Charlie Sheen, as in it might not be performing in a few years, depending. Also, the dealers might not have enough capacity on their balance sheet, in collateral to extend for that risk. Dealers like hookers who sense a bad john, closed their books and said no, I wont do it, no date. Some enterprising dealers, said if you want it, we might do it, but you pay a huge premium to get it.

This caused the swap rate spread (the difference between the fixed side of a swap and its equivalent duration UST) on that corporate paper to go negative  It is normally positive because there is counterparty risk in a swap and none in the UST.  Which means this dislocation is an insane distress signal.  Several factors, excessive corporate issuance, low dealer appetite and not enough collateral to lubricate the dealers caused an inability to absorb due to ill-liquidity.