“Prophesy as much as you like, but always hedge. – Oliver Wendell Holmes, 1861”
Hedge fund trading strategies provide a blueprint for understanding regional banks’ Asset-Liability Management (ALM), such as SVB’s. During the hedge-fund crisis of 1998, market participants were given a glimpse into the trading strategies used by large hedge funds, such as Long Term Capital Management (LTCM). Few of these strategies were as popular or painful as “fixed-income arbitrage.” As a highly leveraged strategy, fixed-income arbitrage effectively bets on the shape of the yield curve. Despite its big role in the LTCM’s fall, the regulators have not internalized this strategy, and its dangers, well enough. In fact, the so-called puzzling facts about the SVB’s business model would make sense once examined as a hedge fund with a “fixed-income arbitrage” strategy. For instance, unlike the traditional model of deposit taking, SVB invested most of the deposits in fixed-income securities. In addition, SVB was unusually exposed to interest rate risks when failed. These characteristics could be explained through the mechanics of fixed-income arbitrage trading. Indeed, the small margins and the massive exposure to interest rate movement are why this strategy is known as “picking up nickels in front of a steamroller.” The problem with becoming a hedge fund for a bank is that a hedge fund can lock up liquidity and ensure investors do not run. Banks do not have such an option, and when they face the run, they either put pressure on the government’s insurance schemes or the stability of the financial system, or both.
An anomaly in the business model of the SVB is that, for a bank, it had a lot of safe fixed-income securities. SVB had about $190 billion of deposits and invested nearly $120 billion of that money in Treasury and agency mortgage-backed securities (MBS). However, this mystery would be resolved once we consider SVB a hedge fund. Hedge funds, including the doomed LTCM, function based on different strategies, including “fixed-income arbitrage” trading. This strategy uses the model of the term structure of interest rate (yield curve) to identify and exploit mispricing among fixed-income securities. For instance, let us assume that the firm’s reading of the Fed is that the central bank pivots toward cutting rates sooner than the market expects. In this case, the firm’s models show a yield curve below the market yield curve. The difference between these two is the so-called “mispricing.”
In this environment, when rates are expected to fall, the fixed-income securities would gain in value, which justifies purchasing government-backed securities such as Treasuries and MBS. Nontheless, the fund hedges the position by entering the relevant swaps to turn such a strategy into “riskless” arbitrage trading. In this case, the fund would enter an IRS and become a fixed-payer and floating-receiver. If the hedge fund’s prediction is correct, the IRS will generate slight cash outflows for the fund. In this case, the floating rate (determining the value of the fund’s cash inflow) would fall while the fixed rate (setting the cash outflow value) would remain unchanged. Nonetheless, and most importantly, the fixed-income securities’ capital gain would compensate for such a slight fall in the value of the IRS. Alternatively, if the hedge fund’s bet was wrong and rates increased instead, the IRS value would rise and neutralize the loss in the fixed-income securities’ fair value. Fixed-income arbitrage has its roots in the fixed-income trading desks of most brokerage houses and investment banks.
However, as LTCM’s failure showed, two critical vulnerabilities are implied in such an apparent risk-less strategy. First, profits generated through fixed-income arbitrage transactions are often so small that managers have to use substantial leverage to generate significant levels of return for the fund. As a result, even a slight movement in the interest rate in the wrong direction could make hedging too expensive to be maintained. This aspect, known to the hedge fund watchers, could explain the behavior of the SVB’s managers to drop the interest rate hedges. In mid-2022, the managers suddenly dropped the interest rate hedges without providing reasonable economic justifications. However, labeling this decision as mere poor risk management can be misleading. The mechanics of the fixed-income strategy explain this behavior more accurately. SVB’s decision to liquidate the swap positions coincided with when the market consensus on the Fed shifted. Fed watchers started to believe a more hawkish tone of the central bank. Fed would tolerate a slight recession and will not reduce rates without substantial evidence of inflation falling. In this environment, it becomes too expensive for the fund that has bet on the fall in interest rate to maintain the hedging aspect of the portfolio.
To understand this point, let us go through an example together. Let us assume that a hedge fund manager takes a long position in 1000 2-year Treasuries for $200. His unhedged position is worth 1,000 × $200 = $200,000. The bond’s annual payout is 6% or 3% semiannually. The bond Duration is 2 years, so the fund would expect to receive the principal after 2 years. After the first year, the amount earned, assuming reinvestment of the interest in a different asset, will be: $200,000 × .06 = $12,000. After two years, the fund’s earnings are $12,000 × 2= $24,000. However, the risks in the above transaction include: (a) not being paid back the face value of the municipal bond and (b) not receiving the promised interest. To hedge this Duration risk, the manager must short a 2-year IRS with a notional value of $200,000. The fund negotiates so that the fixed rate in the IRS is less than the 6% in annual interest, let us say %5.9.
The final hedged position results in the following short cash position for the first year: $200,000 × .059 = $11,800, and for the two years, the fund will pay a total of $11,800 × 2 = $23,600. In this example, if the manager has to pay out a total of $23,600 to hedge his duration risk, we must subtract this amount from the anticipated interest made on the bond: $24,000 −$23,600 = $400. Thus $400 is the net profit made on this transaction. Profits generated through fixed-income arbitrage transactions are often so small that managers drop the hedge when the interest rates move in the wrong direction for a relatively consistent period. This explains the use and the drop of the IRS by the SVB.
An essential problem with fixed-income arbitrage is that maintaining the hedges can be unsustainable for firms adopting this strategy. In addition, empirical evidence shows that the so-called arbitrage opportunity might not be riskless. In fact, the deep losses, and extra returns, might be less due to the high leverage and more a reflection of more profound risks, such as market risks, inherent in the nature of such strategies. Fixed income arbitrage is assumed to be a riskless, market-neutral investment strategy. This strategy is considered market-neutral as it consists of a short position in a swap and an offsetting long position in a Treasury bond with the same maturity (or vice versa). In actuality, however, this strategy is subject to the risk of a significant widening in the fixed (swap rate)-floating (SOFR rate) spread. Suppose this spread is correlated with market factors, which in most cases, it is. In that case, the excess returns may represent compensation for this strategy’s underlying market risk. In other words, this fixed-income arbitrage strategy has little or no riskless arbitrage component.
In addition, this strategy has exposure to a wide array of price risks. In particular, the strategy has exposure to the stock market, the banking industry, the Treasury bond market, and the corporate bond market. In particular, the researchers have shown that the excess returns for these fixed-income arbitrage strategies are related to excess returns for the stock market, excess returns for bank stocks, and excess returns for Treasury and corporate bonds. This suggests that the risk of a significant financial event or crisis is a risk that is priced throughout many financial markets. Thus, the financial-event risk may be a critical source of the widely-documented commonalities in risk premia across different asset classes. These results are consistent with the view that the financial players, including the market-makers and their balance sheet positions, play a central role in asset pricing.
One practice that connects the regional banks’ business model with hedge funds is the Ponzi aspect of their businesses. Both types of firms rely on the continuity of short funding to finance their assets. For hedge funds, the cash inflow is in the form of capital from the investors, while in the case of the banks, it is depositors’ money. Nonetheless, there is one more similarity between these two that is even more fundamental yet is more obscured. At first glance, it might look like regional banks’ holding of fixed-income securities was an attempt to invest in safe assets. However, after examining the SVB’s business models and their managers’ narratives, these investments start to look more and more like the “fixed-income arbitrage” strategy of hedge funds and less like their investing in safe assets. This strategy tries to exploit mispricing amongst fixed-income securities. It is based on the firms’ understanding and modeling of the term structure of interest rate. In doing so, it creates excessively high exposure to interest rate risk. This is because if the fund is betting on the shape of the yield curve, it becomes at the mercy of its financial model’s predictions. If these models are incorrect, interest rate movements will crush their profits. Unfortunately, this is what happened with SVB.
When the dust settles, SVB might be more like a hedge fund than a bank. However, banks becoming hedge funds have implications for financial stability. For example, their business model could be concealed from the untrained eyes of the regulators as long as deposits flow into the regional bank. However, once the profit margin collapsed, the bank had to drop the strategy of acting like a hedge fund as it was no longer hedged. Nonetheless, the difference between a hedge fund and a bank is that hedge funds are designed to earn lots of money and disappear. Therefore, no one misses them once they disappear. However, banks serve a public function, have a government backstop, and occupy a vital role in the financial system. As a result, adopting such a short-term, high-risk-high-profit business model for such an important institution is dangerous for financial stability.
Most importantly, banks, if they decide to restrict people’s access to their deposits, they generate a banking crisis. On the other hand, hedge funds often impose lock-up periods, such as several years in which investments cannot be withdrawn. Many also employ redemption notices requiring investors to provide notice weeks or months before their desire to redeem funds. These restrictions limit investors’ liquidity but, in turn, enable the funds to invest in illiquid assets where returns may be higher without worrying about meeting unanticipated demands for redemptions. The events leading to the banking disruption of March 2023 suggest that market participants or regulators needed to adequately internalize essential lessons from the 1998 hedge fund crisis case. If they did, they could recognize the fixed-income strategy at the heart of the SVB’s business model.