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Hello and welcome to another episode of the Odd Lots podcast.
I'm Joe Wisenthal and I'm Tracy Alloway.
Tracy remember SVB.
I vaguely remember something happening with a bank called Silicon Valley.
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 like did episodes like how should we reform banking? And should banking be semi public and all this stuff, but like nothing happened in the week of it.
Right, No, And in fact, I mean, the basel endgame stuff seems to be pretty much off the table at this point.
But yeah, what, 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? So 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 twenty eighteen 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. And 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 fifth, 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.
And 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 will 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 Saidenishon. She's a term assistant professor of economics at Bernard 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 plying a new lend to it. The paper is called Banks a Synthetic hedge Fund. So, Elham, thank you so much for coming on out lots.
Thank you so much for having me. I'm very happy to be here.
Absolutely, I'm not used to this phrase. So this term synthetic hedge funds, I could sort of take a stab in my mind of what it means. But what is this term synthetic hedge funds mean?
A synthetic hash 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 this is about a replication, but it's about the replication of the return and risk of a hedge fund without being an actual hedge fund. So this is when we call an institution doing what we call SYNTHETI had fun 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.
So basically, a SVP kind of like FeAs in this category from two different perspectives, and like one type of activity is actually being generated through the unbalanced it kind of like operation, and the other one is being generated through off balance it operation. So I want to start with the off balance it operation and then I kind of like continue the conversation to discuss what SWEP has
done and the balance it as well. When it comes to the off balance it operation, it is like the way as we have used interest rates, SWAB replicates what a hedge fund does in order to conduct a fixed income arbitration strategy, rather than what a bank does in order to protect itself against interest rate risk. So, to
be more specific, what do I mean by that? Like when you try to kind of like 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 toob by SVP really replicates what a hedge fund would do in order to kind of like exploit the so called mispricing in the bond market. And that mispricing in the bond market would generate this so called like arbitrage opportunity that a hedge
fund wants to naturally exploit. So I want to start with what happened to the SVB in order to decide
to exit the interest rates to oppositions. So when you look at like the timing of the exit, it just doesn't make sense if you think of a VB 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 US treasuries and a short position in interst rate swap because it was actually thinking that the swop rate, which is the difference between the
swap spread, which is the difference between the swap rate and the US treasure 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 swab spread is not actually going to widen, and in order to minimize as the losses, it tried to kind of like
exed that particular position sooner rather than later. This is the narrative that the SVBCFO was kind of like offering to the rest of us that they tried to minimize losses and that's why they exist the interest rate stop 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 cave, 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 risks because it was holding very long term US Treasury securities. So in short, when it comes to the off balanceet operation, the timing of entering and exiting the swap positions, and the reason the SVIB has actually conducted both operations matched with their understanding of what the yield care should be and what the yield cave is rather than what the interesst 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
the SWEB did. At 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 site 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 capitol 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 is a very unusual type of bank credit.
I just want to ask a question on the swaps, right, So, I remember this came up a lot when the vocal rule was coming into being. But a reality of the way banks are operate is that the line between a hedge and a trade can be pretty thin, and 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 peril and saying in peril about their prediction of what the shape
of the yield care should be. Because when it comes to like most hedge funded strategies, especially the fixed income hedge funded strategies, is all about what a particular head fund manager thinks they yield curve should be and what the yield cave 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 an intere and compose a portfolio that enables the hedge fund to actually
exploit that's so called mispricing. So what I would say is that the defining point here is whether that particular entity, it can be a synthetic hash fund such as a bank or an actual hedge fund, is connecting is activity
with the mispricing in the bond market. And what the shape of the yield cave should be versus what the shape of the yield cave is or what they do think about, like a particular direction in the prices, and then they want to actually kind of like very immediately and short term exploit those particular directional benefits.
So I take your point about Okay, the if I were saying one thing, we're doing a hedge, but some of the stuff doesn't line up, could it be inconfidence? Right? Like, so there's one stay, Okay, 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. And again I want to go back to what they were saying about, like what they think the market is doing,
which they thought is this wrong? And they thought that the swop press are too low, and they thought the swop pres they're 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 see like a hedge fund and it's trying to align his action based on that particular belief about the
shape of the yield cave. And the other important difference between a hedge fund and 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 of strategies, these guys are patients. At least some of these guys are very very patient, and especially in the world of fixing comarbitrash, 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 saw because you just want to trade a particular a derivative in this case SAB versus your intering interest rate SAB because it is
part of your brother portfolio. And I do think that in the case of a SWEEB, the very interest rate SWAB because it was part of a broader portfolio, and that portfolio, the goal of that core portfolio was not to head a particular risk, in this case the interest rate risk of the those US treasuries, but rather the goal was to exploit a mispricing in the yieldcare.
Talk to us about the on balance sheet activities you mentioned them earlier. So alternative credit line, 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, you extend the
loan which earns interest. Your biggest incentive is to actually earn return based on the interest you are actually kind of like earning, and 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, is 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 structured to below. 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 in instead bring those funding gaps through this particle a line of credit.
I explained that, sorry, 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 increases own compensation. So 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 alone is not very attractive. The answer to this question is the type of collateral. The other type of credit lines where the collateral is usually let's say the physical assets or you know, another type of like financial assets. In this case, the collateral is the imployed 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. In this case, the incentive is a structure. In a very interesting way, the incentive for the bank care is a structure 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, and the rate of return for the banker in this case is going to be the
intelal rate of return of the private equity fund, which is considerably higher than the interest rate. In a sense, if you're a banker and if you have extended this 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 sweb'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, and 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 off 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 to posit taking institution that does this, and loads has been written about them over the years, But where are you getting the data from and how are you making that judgment?
So basically like, I am connecting 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. But the good news here is that I'm in touch with a few people in the fat they might extend such a 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 a half hours of the bank cares like the hedge fund association like parties, and I talk to these guys and I'm hearing or and or 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. So 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 they're like multiple things going on. There's the question of is the bank hedging or is the bank trading. There's 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 like 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, I do.
Think it is, and I do think like 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 like data, but rather our framework, the lens s trivish while looking at and also the lens TRUVISI 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 like risk management, and because they just exited their interest rates opposition just before the FED started to increase the rates. So 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 doors higher returns that are actually being accumulated and generated in the private market and also like in
the alternative investment fund market. So 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 charge. Whether it's looking adventure capital, buy out, various forms of private equity, the number of them using subscription lines of credit, pretty interesting charge lines going up into the right, lots.
Of lines going up. So I mean, I agree with the point that supervisors should be looking at this activity. And 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 twenty twenty and 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 eighteen million dollars 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 US Treasury, the holding of the US Treasure is one of the other mistakes they made was that in instead of like accounting for them as health to maturity, they did do that as available for sale, and 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 bank here, I do think they were decent enough bank, but they just didn't like to be that. They wanted to be something beyond that, and that where they weren't really good at. And again I'm going back to 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 care should be and what the yield care is. They thought the swop press are going to increase and in order to actually match their fundamental value, and they thought the swop press are kind of like artificially like
suppress and they wanted to take advantage of that. And they failed dramatically, and mostly because they couldn't wait long enough because they were actually constrained by regulation as well. So for me, rather than thinking that SVB was not a good bank, this is actually showing an inherent tension for any type of banks who wants to actually do something that non banks are doing, especially like alternative investment
funds are doing. That even if you manipulate your models in order to synthetically replicate the trading strategies, investing strategies, or the risk and return portfolio of a hedge fund, you do not have the same flexibility to execute those type of strategies, and you do not have the same time, and you are considerably more constrained in terms of being supervised in terms of like you have to put considerably more capital. This is something that hedge funds do not
need to do. And you have to respond to people who are very impatient, and those are depositors, people that as a hedge fund, you don't need to deal with. So for me, this is an inherent tension between being a bank with all the realities of being a bank, and just think that's not good enough. You want to be something better.
You know, I for a long time, and I still do. Like I consider myself, like Tracy probably heard me at various times, I'm like an SVB apologist, And I've said on the podcast, I'm like, oh, they're like a good bank. They like took themselves really seriously.
Everyone here has a different view. Yeah, whether they were a good bank, that's right.
I think like I'm like in the middle here because I was for a long time. It's like, no, this is like what a bank should be, and they really get to know their clients and they really get to
like know their industry. On the other hand, I agree with like Tracy that they just seem to have made a lot of bad mistakes and miscalculated the flightiness of its depositor base, and they probably didn't have traditional lending opportunities like most banks, so they're like, oh, I'll just put it in something safe, like Treasury is not thinking
about then Treasury sometimes go down. I also home take your review that you know, like you're in Silicon Valley, you probably don't just like want to be a bank, right. You know everyone else is like getting super rich and you're.
Just getting and management is dealing with tech people, right, so I imagine some of that optimism kind of rubs off on them.
Yeah, So it's like everyone else is getting mega ridge and they're just getting kind of rich. So it's like you probably want to look for ways to like get something that resembles equity upside. All this being said, and this is sort of like my final question, the fact that like we're having this conversation, SDB is like a weird situation. There aren't many banks like SVB. I don't think in that one specific industry and an industry that's specific to a location, et cetera. And then there wasn't
much contagion. There were a few other sort of similar banks that went down. There were some crypto related banks, but it was not contagious. In the end, it was not a big crisis of regional banks. It was not a big flight of deposits away. Regional banks DOCS have been doing very well lately and they're like basically they're a little bit above where they are when this PHB colaps. How do you think this is all along winded way to set up like the prevalence of this type of
risk elsewhere. Because it feels to me that SVB intuitively feels like a unique situation.
I should disagree with you, and I don't think it's about the question of like, okay, what happened immediately after I met of the claps of SVB. To me, this is a signal that where the banking is going, and this is about like the commercial banking those are like they're not too as big as Jpmerican. The City Bank
or Bank of America. I do think that the biggest lesson we have to learn from this SVB is that the business model of banking system is changing, and SVB but just showing a window or opening a window towards that new world. That the banks are doing different things. They're manipulating their model in order to take advantage of some flexibility or any flexibility they might have in order
to co undugged hedge fund like strategies. So to me, the collapse of SVB was very important, not because what happened immediately afterwards or the bank run on other banks, but because it is showing us that there is distension in the banking system, that banks do not want to
be banked anymore, and they are looking for alternatives. And these alternatives are usually being found in the alternative investment world, and the banks are going to move towards to the direction of adopting more of that type of strategies into their traditional banking model. And it is in that regard. It is from this perspective that I think what happened to SVB is very important because it is showing us that banks are extremely uncomfortable with their identity and they
want to shift their identity. Is it a bad thing or a good thing? You don't know. I think he's a very exciting thing.
This is Tracy along has my approach to news. No better or good, just exciting.
Yeah, although I was gonna say it was actually pretty amazing to hear you take a middle ground position on something. I don't think I've ever heard that before.
I'm just a normal, moderate guy.
Yeah, okay, So just on this point. One thing I remember from our discussions around SVB. I think we were talking to levmanand and he made the point that the US has basically made a conscious decision to outsource a lot of bank supervisory processes to shareholders. And shareholders, you know, they like making money, and so the incentive is typically
skewed towards more risky behavior. If we decide that we don't want banks to be synthetic hedge funds, what type of regulation or limitations would you envision coming into play.
I want to ask your question in a different way, like, if that's the future of banking, if the banks are actually moving towards this world of being a synthetic hatch fund, I do not think the next regulatory question is how to limit the banks, but how to create a safer environment for them, because the other lesson that we learn, at least I learned from the Oswebi's failure was that one of the reasons they failed was that at some point they realized that they do not have enough time
to fully execute their strategy. Their strategy wasn't necessarily wrong, but they actually prematurely exited that as soon as they thought they might be wrong and they might actually face
so many losses. I know this may sound like a revolutionary point, but I do think if the reality of the banking system is that the banks are moving towards that direction, the first regulatory task is for regulators to change their identity as well, because you cannot force banks to be banks if they do not want to be banks. At the same time, if banks are actually conducting risk care strategies, and if as a regulator you're allowing them to take on some of those risks, maybe you want
to remove some of the protections. What type of protections can be removed so that you can still maintain the stability of the deposit taking world and the stability of the financial system. This is the question that I'm proactively
thinking about it. I do not have the answer for but I don't think the first regulatory step is to limit what banks are doing, but rather for regulators to change their DNA and identity as well and know that they cannot be a simple, plain vanilla bank regulators anymore if banks are not banks anymore and banks want to be something else.
Ohmsday, Denijah, Thank you so much for coming on Oline. We had a little three way debate therapy and there's a lot of fun things. Thank You're so much. Glad to finally have you on.
Thank you so much. It was a pleasure of being here and discussing my ideas with you.
Tracy. I can't believe you've said I've never taken a middle ground before. I don't take any positions.
I just I just like to learn no opinion wise people.
Yeah, that's me, that's me.
I thought that was a really interesting discussion. I mean, broadly, what we're talking about here is reach for you behavior, and whether that comes about through synthetic leverage or something old school like just buying a bunch of long duration bonds and then not hedging the interest rate risk. It kind of amounts to the same thing right, they're still doing this to boost returns.
We should do more on the rise of sublines. There's always one more thing, isn't there.
Yeah. Well, and the other thing I was thinking is this feeds into that idea of banks and private credit private equity being frenemies, right, like they are objectively becoming more intertwined. Insurance companies, by the way, are also big players in private credit now, so it does feel like the trifecta of the three biggest financial industries, banks, private equity slash private credit, and insurers are becoming more intertwined totally.
I mean, it's interesting and it makes total sense, right, if other entities are going to try to become banks or credit, you know, expanding entities as we've been talking about forever, it makes sense that banks are going to want to look for upside elsewhere and maybe take on
positions that resemble more sort of like equity upside. I thought Aham said something kind of fascinating at the end in response to your question about regulation, which is that like, if banks don't want to be banks, like, there's kind
of nothing we can do to stop them. And I think that's like an interesting principle of like financial regulation period that like you know, it is always this cat and mouse game, right and in the end, like there's sort of like entities will evolve into the new thing and at some point there's going to be a blow up and you know, hopefully regulators get ahead of the curve.
But in the end, like it feels like all financial entities of any sort will like they'll evolve into what they want to evolve into.
Yeah, you got to change your opinion when the facts change, right, right, Shoe Joe.
Yeah, that's right.
Yeah, Okay, shall we leave it there.
Let's leave it there.
This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway and.
I'm Joe Wisenthal. You can follow me at the Stalwart. Follow our guest Elham Say She's at el Hamsaiety and check out her recent paper banks as synthetic hedge funds. Follow our producers Kerman Rodriguez at Carman Ermann, Dash, O Bennett at dashbod and kill Brooks at Keil Brooks. More odd law content, go to bloomberg dot com slash oddlock, where transcripts a blog in a newsletter and you can chat about all of these topics twenty four to seven in our discord discord dot gg slash oddlocks.
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