How Banks Turned Into Giant Synthetic Hedge Funds

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0:43That's unlimited data for unlimited business. There we go. Get the internet you need at the price you want. Verizon Business. Starting price for LTE Business Internet, 25 megabits per second unlimited data plan with select Verizon Business smartphone plan savings. Terms apply. Hey there, Odd Lots listeners. It's Tracy Alloway. And Jill Weisenthal. We are very excited to announce that Odd Lots is going to Washington. That's right. For the first time, we are going to do a live public Odd Lots recording in our nation's capital. That's going to be March 12th in Washington, D.C. at the Miracle Theater.

1:21And guests will be announced in the coming days. But in the meantime, you can find a ticket link at Bloomberg.com slash Odd Lots.

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1:46Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Alloway. Tracy, remember SVB? I vaguely remember something happening with a bank called Silicon Valley Bank. Here's actually sort of something I've been wondering about is like, okay, there was this moment where suddenly people got anxious about regional banks and stuff like that. You know, we did episodes like how should we reform banking and should banking be semi-public and all this stuff. But like nothing happened in the wake of it, right? No. And in fact, I mean, the Basel endgame stuff seems to be pretty much off the table at this point.

2:25Oh, yeah. Actually, I haven't been following that. What's happening with that? I don't think it's happening. Michael Barr has like he's left, hasn't he? Yeah. I mean, it seems like there's not going to be a big change on that front. I will also say like one of the interesting things when it comes to bank regulation is there was a 2018 change where I think the Trump administration made it easier for regional banks to do some potentially riskier stuff. And the argument there was that regional banks should be treated differently to large banks. They should be able to do certain things, blah, blah, blah, blah, blah.

3:02And I guess you could argue that that might have fed into some of the SVB drama as well. Actually, it's good that we're talking about this because when we talk about financial markets these days, like so much of it is about tech in particular. But if you go back and look at a chart of KRE, the regional bank ETF, that is another one that was just a straight line up on November 5th. And there's a widespread expectation and I think pretty well founded that the Trump administration is going to have a much more sort of liberal attitude towards financial market regulation than the last administration.

3:36And so we shouldn't go too long with, you know, take our eye off the ball of financial regulatory issues. Because also if history is any guide, like the next thing that happens, like we'll get no warning of it. It'll just happen one day. Yeah. Also, I love talking about banks. Like, let's just do it for bank purposes. Okay. Well, I'm very excited about this episode. It's a guest I've actually wanted to have on for a very long time. We're going to be speaking with Elham Sayedinejad. She's a term assistant professor of economics at Barnard College at Columbia, as well as an adjunct professor at NYU, and also the author of a recent paper sort of revisiting the collapse of SVB and applying a new lens to it.

4:16The paper is called Banks as Synthetic Hedge Funds. So Elham, thank you so much for coming on Odd Lots. Thank you so much for having me. I'm very happy to be here. Absolutely. I'm not used to this phrase or this term synthetic hedge funds. I could sort of take a stab in my mind of what it means, but what does this term synthetic hedge funds mean? Synthetic hedge fund is a type of activity and rather than being a specific type of like firm, and this is when a non-hedge fund wants to replicate the activities of a hedge fund and therefore get the same type of return. And it is about the replication, but it's about the replication of the return and risk of a hedge fund without being an actual hedge fund.

4:55So this is when we call an institution doing what we call a synthetic hedge fund type of activity. Tracy, I already like this conversation because normally we talk about shadow banks, right? And so the idea that there's banks inside regulated institutions and then other non-banks sort of replicate their activity. And it feels like we're looking through the other end of the telescope here talking about, you know, hedge funds being replicated inside regulated institutions. Yeah, it's replication all the way down. But okay, talk to us about how SVB fits into the category of synthetic hedge funds, because I think that'll help us understand exactly what's going on.

5:33So basically, SVP kind of like fits in this category from two different perspectives. And like one type of activity is actually being generated through the on-balance sheet kind of like operation. And the other one is being generated through off-balance sheet operation. So I want to start with the off-balance sheet operation. And then I will kind of like continue the conversation to discuss what SVP has done in the balance sheet as well. When it comes to the off-balance sheet operation, it is like the way SVP have used interest rate swap replicates what a hedge fund does in order to conduct a fixed income arbitrage strategy rather than what a bank does in order to protect itself against interest rate risk.

6:13So to be more specific, what do I mean by that? When you try to match the activities of the SVB risk managers with the narratives of the CFO of the SVB, we see that the timing of entering and exiting the interest rates swap by SVP really replicates what a hedge fund would do in order to exploit the so-called mispricing in the bond market. And that mispricing in the bond market would generate this so-called arbitrage opportunity that a hedge fund wants to naturally exploit. So I want to start with what happened to the SVP in order to decide to exceed the interest rates to our positions. So when you look at the timing of the exit, it just doesn't make sense.

6:59if you think of SVB as a bank that wants to actually hedge itself against interest rate movements. But if you think of it as a hedge fund who has entered this particular position of having a long position in the U.S. treasuries and a short position in interest rate swap, because it was actually thinking that the swap rate, which is the difference between the swap spread, which is the difference between the swap rate and the U.S. treasury rate is too narrow. and like the hedge fund was predicting that this spread is going to widen in the future. But at some point it realizes that that prediction was wrong and the swap spread is not actually going to widen.

7:41And in order to minimize the losses, it tried to kind of like exceed that particular position sooner rather than later. This is the narrative that the SVB CFO was kind of like offering to the rest of us that they try to minimize losses. And that's why they exceeded the interest rates to our position, which again matches with what the very same CFO and very same type of like people from the SVP group were telling us about their prediction about the shape of the yield curve, which informs such a strategy. But it does not align with what a typical bank risk manager would do if it wanted to actually protect itself against interest rate risk because it was holding very long-term U.S.

8:31treasury securities. So in short, when it comes to the off-balance sheet operation, the timing of entering and exiting the swap positions and the reason the SVB has actually conducted both operations matched with their understanding of what the yield curve should be and what the yield curve is, rather than what the interest rate risks are, and they wanted to protect themselves against those type of risks. So if you want to understand it from the traditional bank risk management, this doesn't make sense. If you want to understand it through a hedge fund strategy that want to actually exploit mispricing in the bond market, and then realizes that that mispricing was mistake, that estimation of a mispricing was mistake, then it does make sense to do what SVB did.

9:21At the same time, when it comes to the unbalanced operations, when we look at the asset side of the SVB, there is this item in the asset side, which I think we should explore more, and we haven't done so yet. And that's what we call the subscription line, or a capital call line of credit, which is something that I think is growing in the commercial banking world. And in terms of the economics of this credit line, it's a very unusual type of bank credit. I just want to ask a question on the swap spreads. So I remember this came up a lot when the Volcker rule was coming into being. But a reality of the way banks operate is that the line between a hedge and a trade can be pretty thin.

10:04and hedges can end up being very profitable or they can end up losing a lot of money. How do you actually distinguish between the two? Because again, one man's hedge is another man's trade, right? That's a very, very good question. Like one way to distinguish between the two is that, again, listening to what they are saying and the reasoning behind their entrance and they entering a particular position and they exit from that particular position. So it's really about collecting narrative. That's one thing. The second thing is to match what they are doing with what they also doing in parallel and saying in parallel about their prediction of what the shape of the yield curve should be.

10:47Because when it comes to like most hedge fund strategies, especially the fixed income hedge fund strategies, it's all about what a particular hedge fund manager thinks the yield curve should be and what the yield curve in the market actually is today. And if there's a difference between the two, a hedge fund is going to conduct a sort of inter and compose a portfolio that enables the hedge fund to actually exploit that so-called mispricing. So what I would say is that the defining point here is whether that particular entity, it can be a synthetic hedge fund such as a bank or an actual hedge fund is connecting its activity with the mispricing in the bond market and what the shape of the yield curve should be versus what the shape of the yield curve is, or what they do think about like a particular direction in the prices.

11:48And then they want to actually kind of like very immediately and short term exploit those particular directional benefits. So I take your point about, OK, the CFO is saying one thing, we're doing a hedge, but some of this stuff doesn't line up. Could it be incompetence? Right. Like, so there's one say, OK, this does not look like a hedge. They're making a trade. They're taking some sort of risk that's different from the economics of the bank. Could it just be bad management? It can be, but in terms of SVB, I don't think it was. I do think it was incompetence, but not because they were incompetent in terms of being a bad risk manager as a bank or as a banker, but I think they were a very bad hedge fund manager.

12:31And again, I want to go back to what they were saying about like what they think the market is doing, which they thought is wrong. And they thought that the swap rates are too low and they thought the swap rates, based on the fundamental value, they should be higher. And then when you look at their action, they were actually acting based on that particular belief. And I would not call that incompetence. I would call that someone, in this case, a banker who is actually trying to think like a hedge fund and is trying to align his action based on that particular belief about the shape of the yield curve.

13:08And the other important difference between a hedge fund strategy and a trade, just going back to the previous point, is that a trade is usually shorter term. But when it comes to the hedge fund strategies, these guys are patient. At least some of these guys are very, very patient. And especially in the world of fixed income arbitrage, you need to be patient. But when you are acting, you need to be very quick. And that's also one of the distinctions between just like you are entering the interest rate SOAP because you just want to trade a particular derivative, in this case, SOAP, versus you are entering interest rate SOAP because it is part of your broader portfolio.

13:45And I do think that in the case of SVB, they were entering interest rate swap because it was part of a broader portfolio. And that portfolio, the goal of that portfolio was not to hedge a particular risk. In this case, the interest rate risk of those U.S. treasuries, but rather the goal was to exploit a mispricing in the yield curve.

14:15Thank you.

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15:26EasyCater, your business tool for food. To learn more, visit easycater.com slash podcast. Talk to us about the on-balance sheet activities. You mentioned them earlier. So alternative credit lines, subscription lines. How did those actually factor into this idea of SVB being a synthetic hedge fund? That's a very good question. And when it comes to the capital line of credit, there are so many interesting differences between this particular credit line and a typical bank credit line. I want to start by saying something which is very different from what banks do. So as a bank, when you extend a line of credit, when you extend a loan, which earns interest, your biggest incentive is to actually earn return based on the interest you are actually kind of like earning.

16:15And your biggest fear is for the guy, for your counterparty not to show up. You don't want to actually be engaged in this type of credit activity. But when it comes to the capital line of credit or subscription line, it's actually the opposite. When it comes to the interest rate on these lines of credit, the interest rate is actually very low. They are a structure to be low. They are a structure to be too low so that in this case, this is actually a line of credit between the bank and usually a private equity fund manager. So the interest rates are very low because you want to attract those private equity fund managers to come to you and actually postpone the capital call and instead bridge those funding gaps through this particular line of credit.

17:04Explain that. Sorry, I don't understand that. Basically, like the first thing is that these subscription lines are not a credit line between a bank and a private equity. It is a credit line between a bank and a private equity fund manager. So the reason the private equity fund manager goes to the bank in order to kind of like establish this line of credit is that they want to postpone capital call from their limited partner, because that's how the private equity fund manager can actually kind of like synthetically or artificially increase the internal rate of return and therefore increase its own compensation.

17:47So we know why private equity fund manager is doing so, but why the bank is involved in this type of activity, given that the interest rate on this particular loan is not very attractive. The answer to this question is the type of collateral. Unlike the other type of credit lines, where the collateral is usually, let's say the physical assets or another type of financial assets, in this case, the collateral is the implied liability of private equity limited partners. Even though these limited partners may have no idea. As a matter of fact, they do not have any idea that this line of credit has been established at all.

18:34In this case, the incentive is structured in a very interesting way. The incentive for the banker is structured so that if for any reason the private equity fund manager doesn't show up and does not clear the loan or the line of credit and it defaults, that's where the money and the profit and the attraction is going to be for the banker. So what is going to happen in this case? In this case, the banker can use what we call the power of attorney, and then it becomes a synthetic limited partner in that particular private equity. And the amount of loan, the amount of credit that was extended to the private equity fund manager, now is going to be like as if the banker was actually one of the limited partners in that particular private equity investment.

19:33And the rate of return for the banker in this case is going to be the internal rate of return of the private equity fund, which is considerably higher than the interest rate. In a sense, if you are a banker and if you have extended these type of line of credit, you're just like praying and like you're hoping that the fund manager doesn't show up so that you become the synthetic private equity fund manager. So in this paper, basically, I am actually highlighting this activity, which was actually a significant part of SVB's activity as well, to say that in this case, what the banker wants to be is to become a synthetic private equity limited partner.

20:21And this particular line of credit is enabling the bank to do so. And I also want to say something about the prospect of like other banks using this. This is actually a growing business. Wells Fargo now does have a whole department trying to exploit this type of line of credit. And I do think if a bank is interested in this, it is because the bank wants to become a synthetic private equity investor. Wait, talk to us more about how endemic this actually is. And I'm curious as well, like how you know that other banks are doing this. And I can think of one deposit taking institution that does this and loads has been written about them over the years.

21:05But where are you getting the data from? And how are you making that judgment? So basically, like, I am conducting this research on market microstructure. And this project is called Market Microstructure Project. And because of this project, I am actually kind of like reading everything that the bankers, the fund managers are saying, like, in the news, in the newspaper, in the news articles. So to answer your question, I would say that unfortunately, as of now, I do not have access to the data set that gives me this kind of like concrete picture of like how many banks are actually using these subscription lines or extending these subscription lines.

21:46But the good news here is that I'm in touch with a few people in the Fed. They might extend such data to me. So this is hopefully going to be the next project for me to formalize that and showing that in the data. But I'm collecting narratives. I'm listening to the people. And also because of this market microstructure project, I'm talking to all the bankers. Like I go to this, like, let's say happy hours of the bankers, like the hedge fund association, like parties. And I talk to these guys and I'm hearing over and over again that like the bankers are either using this in their business model as part of their business model, or they are trying to actually adopt it.

22:25So as of now, this is me as the one professor who is just trying to listen to the market. But hopefully this is soon going to be formally shown to the rest of us through the data that I will have access to. So there are like multiple things going on. There's the question of is the bank hedging or is the bank trading? There is the question of are they trying to establish collateral that's in a sort of like hedge fund or private equity structure so that they can get higher returns? and so forth. If the data is available, is this the type of thing that you believe is detectable in advance? This bank is starting to look more like a synthetic hedge fund than what we think of as the economics of a bank.

23:08I do think it is. And I do think the data is an amazing source. And I'm very glad that the central bankers, at least, they do have access to so many data. At the same time, I think right now there is not that much the question of data, but rather our framework, the lens through which we are looking at, and also the lens through which we are looking at this data. If you are looking at the same data and the only framework that you have adopted is the industrial organization of a bank, you're going to see what you want to see, that this was a bank who did a very bad and even a stupid type of risk management, because they just exited their interest rate swap position just before the Fed started to increase rates.

23:52So it is about the industrial organization that you adopt in order to assess the data that is being provided to you by banks. And I really think that in order for the regulators not to fail, it's not that much the question of supervision. I think banks are being supervised, but you have to supervise and assist the bank through new perspectives and understand that the banks do not want to be banks anymore. And they want to actually have some share of those higher returns that are actually being accumulated and generated in the private market and also like in the alternative investment fund market.

24:33So once you look at what banks are doing through the business model and industrial organization of alternative investment fund, I think then you can become even a more effective bank supervisor. By the way, Tracy, I'm looking at a blog post right now from MSCI, and it doesn't look at it from the bank level, but through the fund level. You can just see the rise in charts, whether it's looking at venture capital, buyout, various forms of private equity, the number of them using subscription lines of credit is pretty interesting. Charts, lines going up and to the right. Lots of lines going up. So, I mean, I agree with the point that supervisors should be looking at this activity.

25:14And we probably don't want banks to be synthetic hedge funds. We don't want them to do risky things because we would all like to one day get our deposits back. But in the case of SVB, I don't think I agree with the point that they were a bad synthetic hedge fund versus just a bad bank. And I guess my question is, like, is this the right thing to focus on for SVB? Because even without the swap spreads, SVB's bond portfolio would have had massive losses, right? And they also misjudged their deposit base. That's a pretty big failure for a bank. And by the way, I saw a presentation that was made to their Asset Liability Committee in late 2020.

25:58And the recommendation there from the Treasury was to buy shorter term bonds as deposits were flowing in. and the ALM committee basically decided not to do it. They said like, if we do it, it'll cost$18 million in earnings. So they didn't want to do it because they wanted to protect their profits. But it seems to me like there are some bigger issues here. Really good question. I still do believe that SVB was a good bank, a very bad alternative investment fund. And also they weren't very good like in accounting. So like speaking of the U.S. Treasury, the holding of the U.S. Treasury is one of the other mistakes they made was that instead of like accounting for them as held to maturity, they did do that as available for sale.

26:47And that was also one of the reasons that their balance sheet was negatively affected. So if anything, they weren't really good accountant. But in terms of like being a banker, I do think they were a decent enough bank, but they just didn't like to be that. They wanted to be something beyond that. And that's where they weren't really good at. And again, I'm going back to like the narratives that I collected, and these are all public narratives. And when you look at why they did what they did, they really had a very, very specific view of what the yield curve should be and what the yield curve is.