Hedge Funds – Love Thinking about Finance, Market Microstructure and Money View

By Elham Saeidinezhad

This piece is published initially in Phenomenal World Publications.

Executive Summary

In this piece, I examine SVB’s business model as a model of modern commercial banking. SVB has failed, but its business model will be reincarnated as modern banking. So, what would be modern commercial banking?

Liability Management

– The nature of depositors in large commercial banks shifts from uninformed to informed, such as fund managers.

– Bank’s behavior makes deposit-taking activity into a Ponzi scheme than traditional banking.

Asset Management

– Traditional bank loans to businesses will die. Instead, the banks lend to alternative investment managers themselves through financial engineering methods such as “subscription lines.” This makes banks an investor in the PE world rather than a creditor.

– This business is not that lucrative unless the fund managers default and bankers become the de-facto investors.

– Nonetheless, the loan directly to fund managers and the resulting relationship with them brings a stream of large deposits to such banks, hence the Ponzi.

– Banks invest heavily in fixed-income securities. Nonetheless, the investment strategy is not based on holding safe assets but on following hedge funds’ trading strategies, such as “fixed-income arbitrage.”

-In other words, banks’ investment in fixed-income and hedging strategies will be a bet on the arbitrage opportunities implied in the interest rate term structure. In doing so, they become excessively exposed to interest rate risk.

Vulnerabilities/Structural Shifts

– Lots of unknown ones.

– It will be the death of “Held-to-Maturity” accounting and the birth of “marked-to-market” ones.

-Informed investors keep mark to market banks’ assets and become ultrasensitive to interest rate risks and unrealized losses.

-In other words, banks will become a mixture of investment funds, such as hedge funds and PE funds, but with public support.

Introduction

Silicon Valley Bank’s (SVB) short lifespan—from October 17, 1983 to March 10, 2023—has been witness to crucial transformations in the world of modern banking. The bank’s collapse has sparked wide ranging reflections on the roots of the crisis, the utility of government bailouts, and appropriate responses. I identify two crucial shifts in the banking system exemplified by the Bank’s fall. On the liability side of SVB’s balance sheets, the shift from uninformed to informed depositors renders hedging against interest rate risk more critical. On the asset side, a strategy of “fixed income arbitrage” means that regional banks fell into similar difficulties as hedge funds—one in which low profits rendered betting on the shape of the yield curve too expensive to maintain.

From uninformed to informed investor

Among a number of channels, the crisis has been interpreted according to the classic Diamond-Dybvig Model. This model assumes that depositors in a particular bank are uninformed: as long as they do not reach the $250,000 threshold, they do not distinguish between depositing money in a bank and buying treasuries, given that both investments are backed by the government. As a result, they do not need to evaluate the financial health of their deposit-taking institutions. Driven by “animal spirit” rather than the details of financial statements, they are capable of generating a run on the bank based on “any” worries, imaginary or real. The surest way to stop a bank run, the model thus argues, is through deposit insurance, which stabilizes investor confidence.

However, recent events deviated significantly from these expectations. Rather than being motivated by a herd driven shift in “animal spirits,” the depositors who initiated the runs on SVB, Signature, Silvergate, and other regional banks were informed. Even prior to the run, they were known to extensively tweet about each detail and footnote in the financial statements of their bankers. In the case of SVB, for instance, they examined the bank’s balance sheet and “marked to market” its assets, revealing its exposure to interest rate risk. When the bank reported virtually no interest rate hedges on its massive bond portfolio, investors depositors instigated a bank run.

This distinction between traditional, uninformed depositors and modern, informed ones reflects a revolution in the structure of contemporary banking. In the first phase of this structural change, which took place during the 1950s, “retail” depositors were replaced by “institutional” ones such as pension funds. Though institutional investors injected far greater amounts of cash, they ultimately remained uninformed. They cared little about the financial condition and balance sheets of the banks that received their deposits, and instead prioritized the rate available on an FDIC-insured deposit. So long as they did not breach the $250,000 limit, putting money in a bank appeared as safe as buying Treasuries—particularly given that both investments had full government backing. Consequently, banks around the country, including the shaky and the sick, were flooded with money so long as they posted attractive rates.

With the strengthening of liquidity ratios in the aftermath of 2008, systemically important financial institutions like JPMorgan Chase, Credit Suisse, and Bank of America increasingly transformed into market makers in wholesale money markets, buying and selling securities for their own accounts and thereby minimizing their deposit-taking activity. Liquidity requirements like liquidity coverage ratio (LCR) required banks to have enough high-quality liquid assets to survive thirty days of deposit outflows in a stress scenario. In doing so, they rendered short-term deposits, and the illiquid assets they fund, less appealing.

Big banks coped with these liquidity requirements by reducing deposit-taking activities, leaving medium-sized and large regional banks to pick up the slack. These banks sought to compensate for greater deposit-taking through other financial pursuits. In particular, they were betting on higher returns and attracting new deposits from a piece of financial engineering known as “fund subscription lines.” These credit facilities were different from a traditional business loan on three main fronts. First, a subscription line is a loan to venture capitalists (VC) and private equity fund managers themselves rather than the actual businesses. Second, unlike traditional corporate loans that use the firms’ assets as collaterals, subscription lines are secured against unfounded capital commitments by private equity investors. Finally, banks anticipate returns not through interest accrual but capital gains once the investment is finalized. In other words, subscription lines transformed regional banks into private equity investors rather than creditors.

Subscription lines appealed to venture capital and private equity because they enabled them to manage their cash flows and increase the internal rate of returns on their investments without issuing a capital call to their investors. As such, they increasingly constituted the primary clientele for subscription lines. While big banks fundamentally altered the market-making business, large regional banks’ changed the banking and deposit-taking world. On the liability side, the current banking era started with the “death of the retail deposits.” On the asset side, the trend continued with the death of traditional loans. Instead, VCs and startup depositors obtained liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions, and other fundraising activities. In this environment, regional banks, such as SVB, used Ponzi-like schemes, such as the fund subscription lines, to maintain the steady stream of deposits and become a stakeholder in the alternative investment world.

Marcy Stigum called this the “death of loans” in the late 1970s. This shift transformed banks’ asset management beyond their embrace of subscription lines. SVB and other specialized banks that served informed depositors practically eliminated their loan-giving activity. Lacking fixed assets or recurring cash flows, startups, and crypto investors were less reliable corporate borrowers. But more importantly, these customers did not need loans—equity investors provided them with a constant supply of cash. Consequently, banks shift their operations from issuing loans to purchasing fixed-income securities. In the case of SVB, government bonds became a large portion of the bank portfolio.

The shifts in the nature of depositors, from uninformed to informed, and the assets-liabilities management of banks contributed to the current banking mania. As a result of the large-scale addition of long-term bonds backed by the US government to banks’ portfolios, these specialized banks are unusually exposed to “interest-rate risk.” While most banks earn a higher interest on their loans during interest rate hikes, banks like SVB and Signature are stuck with long-duration bonds whose value goes down as rates go up. Every bank borrows short to lend long, but many banks ultimately strike a balance. Moreover, informed depositors continuously pay attention to the financial statements and footnotes of the banks in which they deposit. As a result, they constantly “mark to market” the banks’ financial assets and penalize them whenever the fair value of their assets is at a loss.

A brief example demonstrates the systemic importance of this point. Let us assume that a bank has $100 worth of deposits as its liabilities. On the asset side, the bank uses cash to purchase a government bond worth $100. In the meantime, the Fed announces a rate hike from 0 percent to 2 percent. A traditional depositor would account for the bank’s assets “at cost,” using the price the bank paid to purchase those bonds, in this case, $100. This is especially true if the bank has announced that these assets are intended to be “held to maturity.” An informed depositor, by contrast, continuously “marks to market” the value of the bank’s assets. In this case, they account for the value of the bonds at their fair market value. When interest rates go up, this value falls: if a bond is issued with a 5 percent coupon and the market rate rises to 8 percent, demand for the 5 percent bond declines. Consequently, its price must fall until its expected return matches the competitive return of 8 percent. Informed depositors know this—if the bank has a bond with a face value of $100, they will check the market price for that bond when the Fed announces its interest rate policy. If, for instance, it is $97, then the bank’s asset is only worth $97 on its balance sheet. The other $3 is gone, and the bank is considered insolvent. Informed depositors notice—they write long tweet threads, initiating a bank run. In doing so, they heighten the bank’s exposure to interest rate risks, particularly if the bank is invested in fixed-income securities, such as government bonds.

Fortunately, this shift also opens up new directions for bank run management: interest rate hedges. Often in the form of swaps, this financial instrument effectively turns an investor’s fixed-rate loans or bonds into floating rates by paying a third party. Once available for sale, the value of outstanding bonds can be protected if combined with interest rate hedges like swaps. Swaps transform the nature of an asset by converting a fixed-income investment into a floating-rate one and vice versa.

Consider SVB in our earlier example. A proper swap could transform SVB’s bonds earning a fixed interest rate into an asset earning a floating interest rate. Suppose SVB owned $100 million in bonds that will provide 3.2 percent for two years and wishes to switch to the floating rate. It contacts a swap dealer, such as Citigroup, and enters into a swap where it pays the fixed rate (3.2 percent) and receives floating plus 0.1 percent. Its position would then have three sets of cash flows: it receives 3.2 percent from the bonds, and the floating rate under the terms of the swap, and pays 3.2 percent under the terms of the swap. These three sets of cash flow net out to an interest rate payment of floating plus 0.1 percent percent (or floating plus 10 basis points). Thus, for SVB, the swap could transform assets earning a fixed rate of 3.2 percent into assets earning the floating rate plus 10 basis points.

The real question underpinning the current crisis then, is why SVB reported virtually no interest rate hedges on its massive bond portfolio at the end of 2022. On the contrary, its year-end financial report notes that it terminated or let expire rate hedges on more than $14 billion of securities throughout the year. The US government’s offer of unlimited deposit insurance has failed to calm markets, in part because it assumes the uninformed depositor behavior characteristic of the Diamond-Dybvig Model. But in reality, the banking world has changed: well-informed depositors treat their deposits as an investment vehicle. In this new financial reality, bank runs may be better dealt with using a proper hedging strategy. Strangely, the crisis teaches us that the current regional banking market structure may be better served by a private risk-management solution, available through the derivative markets.

Regional banks as the new hedge funds

The hedge fund crisis of 1998 offers a blueprint for understanding regional banks’ asset-liability management today. At the time, funds like Long Term Capital Management (LTCM) relied on a very popular, and very painful, strategy known as “fixed-income arbitrage.” 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 gain in value, justifying the purchase of government-backed securities like Treasuries and mortgage-backed securities. Nonetheless, the fund hedges the position by entering the relevant swaps to turn such a strategy into “riskless” arbitrage trading. In this case, the fund enters an interest rate swap (IRS) and becomes 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. Most importantly, the fixed-income securities’ capital gain would compensate for the 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.

As LTCM’s failure showed, the strategy contains critical vulnerabilities. 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. With small profit margins and greater exposure to interest rate movement, fixed-income arbitrage has been described as “picking up nickels in front of a steamroller.”

There are many reasons to think SVB’s business model has come to resemble that of hedge funds. Unlike the traditional model of deposit taking, SVB invested most deposits in fixed-income securities. Of its $190 billion in deposits, it had invested $120 billion into Treasury and agency mortgage-backed securities. Conscious of the limitations of fixed-income arbitrage, SVB’s managers suddenly dropped the interest rate hedges without providing reasonable economic justifications in mid-2022. But attributing this decision to poor risk management can be misleading. SVB’s decision to liquidate the swap positions coincided with a shift in the market consensus on the Fed—towards the perspective that the Fed would tolerate a slight recession and will not reduce rates without substantial evidence of inflation falling. The shift made it too expensive to bet on the fall in interest rates.

But this strategy becomes even more dangerous in the hands of a bank. Whereas a hedge fund can lock up liquidity and ensure investors do not run, banks can only pressure government insurance schemes or threaten the stability of the financial system. While hedge funds can impose momentary lock-up periods, bank restrictions on deposits access generate a broader banking crisis. Finally, hedge funds can employ redemption notices which require investors to give weeks or months of notice before redeeming funds, thereby enabling investment in illiquid, high-return assets.

The transformation of banks into hedge funds thus bears enormous implications for financial stability. Their investment strategies are yet to be identified by regulators—so long as deposits flow into the regional bank, it can maintain its hedges. But unlike hedge funds, which are expected to periodically disappear, banks are meant to serve a public function, have a government backstop, and occupy a vital role in the financial system. For the sake of financial stability, they should not be engaging in a short-term, high risk, and high profit business model.

Through the shift to informed investors, and the utilization of hedge fund investment practices, the SVB crisis holds significant consequences for the structure of contemporary banking, and the tools available to prevent future collapse.

“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.