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Comment by chewz | Hacker News Reader

This is rather silly explanation of what happend, especially from JP Morgan...

Everyone who have ever managed bond portfolio knows that he must hedge interest rate risk. And every bank is doing that. SVB didn't.

Since April 2022 till January 2023 SVB had vacant position of Credit Risk Officer.. And the explanation is simple - SVB's former head of risk, Laura Izurieta had left after 1Q2022 when looses from bond portfolio started to grow. She has probably already realized the final outcome as this is ABC of risk management (and in April 2022 the path of rate increases had been already set in motion by FED).

Now look at the timing of insiders selling shares of SVB...

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Which part is silly though? The JPM report is indeed essentially saying that they didn't properly hedge interest rate risk.

It just adds that SVB's situation was exacerbated by the fact that the health and size of the deposit base they had cultivated was also inversely correlated with interest rates (ie VC and startup activity declines with rising rates), which made their situation even more precarious than at other banks.

> Everyone who have ever managed bond portfolio knows that he must hedge interest rate risk.

Just a thought: the UK gilt crisis in December was related to pension funds holding long term gilts. And these pension funds all properly hedge the interest rate risk, they normally don't care how rates evolve.

However, the market value of the gilts was changing too fast for the hedging to work. My understanding is that money couldn't be moved around fast enough to meet margin calls. Which then caused a bad feedback loop of forced liquidations of gilts, and the Bank of England had to step in to handle the crisis.

So with this new story of duration risk at SVB, I'm wondering now whether other banks are in danger. They may have hedged their duration risk, but what if the hedging mechanism turns out to be broken?

> the UK gilt crisis in December was related to pension funds holding long term gilts

No, you got it wrong.. UK pension funds didn't have much gilts. UK pension funds had swaps on gilts and mostly assets equal to long term gilts (AAA rated). Like for example ownership of a parking lots in Germany, apartments in Norway - safe, steady cash flows. This is what chasing yields at zero interest rates does.

Penions funds needed a window of few days to make a fire sale of these assets to meet their margin calls. It takes about two weeks from some junior analyst from BlackRock visiting said parking lot in Germany, checking books to BlackRock depositing money at UK Pension fund bank account. So Bank of England opened unlimited discount window for UK Pension funds for about two weeks. And then it closed.

This is what happend.

Thanks for the correction, I indeed misremembered where exactly the margin calls came from.

I guess the gist of the point I was trying to make still stands though. SVB was not the first fallout from rising yields on long duration assets. There is probably more improper hedging of duration risk out there.

> I guess the gist of the point I was trying to make still stands though.

Of course it does..

it's even worse than that. the pension funds were selling swaps (paying variable rates). that's why the BoE needed to step in to buy gilts - to drive the yield down and stop the bleeding from both the variable payout and capital losses incurred when liquidating gilts at a loss.

zirp has caused some pretty astounding fuckups and i'm sure there are many more to come.

https://www.reuters.com/markets/europe/why-are-britains-pens...

> Everyone who have ever managed bond portfolio knows that he must hedge interest rate risk. And every bank is doing that.

How are other banks hedging interest rate risk?

And how is the opposite end of this hedge hedging their position?

> how is the opposite end of this hedge hedging their position?

Plenty of financial functions create natural short interest rate exposure. Like SVB, they have no business speculating on rates, so they hedge it away. (The Fed is also involved in the repo market.)

Interest rate swaps maybe. Svb would be on the side that is getting a floating rate payment, while they pay a fixed one to the other side, so when the rates increase it would offset the loss in bond price. Thing is I’m not sure if they need to hedge if the bonds are for 1 year because they will get the money back anyways

Any regular bond holding would include a mix of maturities - 1, 2, 5, 10 year bonds. This provides constantly maturing bonds leading to liquid cash with yield on the longest term instruments.

what’s the point of needing to hedge if you let the bonds expire and get the payment. You wouldn’t lose anything right?

SVB just went bankrupt pursuing that strategy...

That being said, I don't think it's possible for all banks to hedge interest rate risk. The risk, to the system as a whole, doesn't go away just because it's transferred to someone else.

Swaps do indeed transfer that risk to other parties, at a premium because those other parties are more able to absorb the risk. While, sure, there are systematic stresses across the whole financial system, it doesn't mean that there aren't counterparties more capable of managing interest rate risk and willing to do so for a fee. This can be done by just having a larger balance sheet, or blending durations.

Seems like SVB wasn't willing to pay the premium, though.

Who are these counterparties that can absorb trillions of dollars in interest rate risk?

My amateur understanding is that this counterparty would need to be short long bonds, ie. be a bond issuer. And they would need to be interested in exchanging their fixed interest rate for a variable one.

If the above is correctly understood I don't see how banks can find issuers of trillions of dollars worth of bonds that want a variable interest rate in a rising interest rate environment.

It’s very expensive to buy hedges when the event they’re protecting against is actively happening. The point would have been to find that counterparty ahead of the time and still pay a hefty premium.

If I’m taking the variable end of a swap and expecting interest rate hikes, I can use the spread I’m gaining to offset the damage to a portfolio I already have of shorter duration (thus: less interest rate sensitive) bonds.

Overall, the USG issuing trillions of dollars of low interest bonds and then raising rates is going to cause losses for bond holders throughout the system, but as long as those bonds are held, in aggregate, in portfolios and entities which won’t face liquidity crises until they mature, the loss can be borne.

There may also be more sophisticated ways of offsetting bond exposure, but I’m not familiar. I’m appealing more to the idea that this impact by the Fed is easy to predict, indeed exactly the point. Bond valuations drying up will reduce the multiplier and take money out of circulation. The system is supposed to remain capitalized (and/or hedged) to survive the stress and the Fed would be watching. Apparently some parts of the system weren’t. And there are calls for the Fed to slow down. And probably more evidence that banking regs need to remain strong.

The system risk can be reduced when someone who’s positively exposed to rising rates trades exposure with someone who’s negatively exposed to rising rates.

For example, pension funds often benefit from rising rates because they plan on paying out future liabilities with current assets and landlords are negatively exposed to rising rates because they own a stream of income in the future. The trade of interest rate exposure between these parties helps both achieve more stability.

A real world example would be taxi drivers trading weather risk with ice cream vans. One party benefits from wet weather that stops people walking outside and the other benefits, so they can trade exposure in a way that makes the system more stable.

So their bond prices went down and made them bankrupt, how does the math work in simple terms?

(as I understand it, and I could be wrong... and if so, please correct me)

The difference between the 10 year and 3 month bonds - https://ycharts.com/indicators/10_year_3_month_treasury_spre...

You'll note that you can get more money buy buying a 3 month bond rather than a 10 year bond.

So, now if you want to sell a 10 year $100 bond, you'll need to sell it for less than what a 3 month $100 bond costs to buy... which is $100.

https://ycharts.com/indicators/3_month_t_bill (look at 3 year chart range) and https://ycharts.com/indicators/10_year_treasury_rate (again, look at 3 year range).

The 10 year $100 bond is still going to pay out at a profit... in 10 years. But there's more valuable things that one can do with $100 in the shorter term so any sales of that before it pays out will be done at a loss.

In simple terms, a bond is a piece of paper that pays a dollar amount per year to the holder for N number of years, after which the initial price paid for the bond is returned to the holder.

For example, a 10-year bond that pays $2 per year costs $100 today. That is, a piece of paper that pays $2 to the holder every year for 10 years, after which the holder gets its $100 back.

Now, some time passes and the market thinks the above bond is too expensive. Instead, the market will only pay $50 for the above bond, ie. $50 to get $2 per year.

This means that the price of another bond: the bond that pays $4 per year will now cost $100. This is the case because holding two bonds that cost $50 each and pay $2 per year is exactly equivalent to holding a single bond that pays $4 per year and costs $100.

If the market price of a 10-year bond that pays $4 per year costs $100 then we say that the current rate of interest for the 10-year bond is 4%. If this rate of interest falls to 2%, it simply means that the market is now willing to pay $200 per year for a bond that pays $4 per year — or, equivalently, $100 for a bond that pays $2 per year.

> after which the initial price paid for the bond is returned to the holder

Probably better to say "face value". The initial price paid for the bond may well not be its face value.

100% agree, taking huge unhedged duration risk and then loading up on negatively convex MBS again unhedged is so crazy.

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