To Hedge Or Not to Hedge

Mispriced Risk

Yesterday, Silicon Valley Bank lost 60% of its value. Today, it lost 68% more of its value. I wrote a piece about it here. Today, First Republic Bank, a competitor to SVB lost 16% of its value today after losing yesterday. We don’t know about FRB, but we do know they compete head to head with SVB.

Accountants always see things in the rearview mirror. They find things and explain them after the fact. This is not a knock on accountants. It’s just a function of what they do and the way the operations of the profession are executed. Francine McKenna was an accountant and now writes about it. Today in a protected tweet so I can’t repost it she said the risk committee of the SVB Board met 22 times last year. Most risk committees of banks meet 5-7 times. They didn’t have a person at the bank in charge of risk, no Risk Officer.

It’s clear, something was very wrong at SVB but no one reported it and no one asked because you assume that a bank keeps a risk officer handy since it is in the business of LOANING MONEY.

Turns out, according to Robert Armstrong at the Financial Times the entire portfolio at SVB was unhedged. I’d link but that article is behind a paywall. Given that SVB lost $1.8 Billion selling US Treasuries and Mortgage Backed Securities yesterday, my assumption is they were naked long the market and when the Fed moved last year they saw the economic losses piling up, and were hoping they didn’t have to sell to actually take an accounting loss. It is amazing to me how many people do not understand that simple investing fact.

But, suppose they had hedged. What does that look like? How does the money travel? Here is a very simplified example. This stuff can be very complex. The complexity is why there are so many futures and options interest rate products to use in order to hedge positions.

Let’s assume this is 2021. 3 month US Treasury bill rates were well under 1% and closer to .25% interest.

The first thing that happens in the bank is someone deposits money. In SVBs case, suppose Rocket Startup raised a $30MM Series A round of financing. Venture capital firms wire the entire amount to Rocket at once. They are sitting on a pile of cash.

Rocket calls up their banker at SVB and tells them to be on the lookout for a big deposit. $30MM goes into the SVB coffers under the name of Rocket Startup.

The bank has $30MM to play with but of course, it is on the hook to deliver money to Rocket Startup when Rocket needs it. The bank and Rocket have a conversation about burn rates and how much they think they will need monthly to survive, and it also enlightens the bank about how long Rocket thinks the money will last.

For the sake of example, let’s say Rocket thinks it will last 18 months. Rocket needs to draw down roughly $170,000 per month. The bank will need to invest the $30MM into safe and liquid assets so it can deliver the money to Rocket while earning some interest on the side which goes right to the bank’s profit and loss.

If we look at the CME interest rate market, there are several products they can use to hedge. Knowing the timing, the bank can easily use a variety of products to hedge the $30MM. The three best products would be Fed Funds, SOFR, and Eurodollars.

The bank would sell a combination of these products to hedge the deposit. They’d do what’s called a “ladder” selling various amounts at various expirations. As the contract expired, the money would go from the brokerage account back to the bank. The bank would pocket the difference in price from the time the hedge was put on, to the time the contract expired. If the bank lost money on the hedge, it would be required to send money to their brokerage—-except if they lost money on the hedge they would have made money on their cash treasury investment which would ameliorate much of the loss. That’s why they call it “hedging”.

What happened in 2022? The Fed moved big time. Here is a graphic.

The huge downward line from 100 to today’s price of 94.38 reflects the Fed raising interest rates over the last year. If SVB had sold at the time they received the deposit, which would be roughly 99.90 here is how the math works on a per contract basis.

.9990-.9438=.552. Multiply 552 ticks times 25 (the minimum tick value)=$13,800 per contract profit, or $414,000 for all $30MM.

To be clear, it would not be a perfect hedge and there would be some brokerage and operational costs associated with putting the hedge on which would eat into the profit margin for the bank. Most contracts are either denominated in $1MM or $100K contract sizes, so there would be a little “roughness” around the edges given the $170K per month needs of Rocket Startup.

But, the bank wouldn’t have lost $1.8B and they’d still be in business today.

(the emailed post had a math error that I subsequently fixed, so don’t jump on me!)

POSTSCRIPT:

At 8:54 AM PT, I opened up Twitter to find out the FDIC seized the SVB. It’s out of business. Wow. That was faster than FTX.