Money Stuff: The Synthetic Lender of Last Resort

One dumb way to think about “the basis trade” is that asset managers want to borrow money to buy Treasury bonds, and asset managers want to lend money against Treasury bond collateral, and for some reason big hedge funds sit in the middle. The trade is:

1. A bond manager wants exposure to Treasury interest rates, but she does not want to just buy Treasuries, because that will take up too much of the cash that she wants to use to buy corporate bonds. So instead she buys Treasury futures, which are like owning Treasury bonds but do not require nearly as much cash.
2. A hedge fund sells her the futures and hedges them by buying the underlying Treasury bonds. It is not betting on rates going up or down; it is simply clipping a fee for providing this service to the bond manager.
3. The hedge fund also doesn’t want to put up all that cash to buy the Treasury bonds; it runs a pretty lean balance sheet and the returns on this trade — the reward it gets for the service it provides — are low. Instead, it borrows most of the cash it uses to buy the Treasuries.
4. A cash manager (a money market fund, pension fund, corporate treasury or other cash investor) lends the hedge fund the money, secured by the Treasuries. [1] This is a pretty safe loan, because the cash investor gets the Treasuries as collateral, and those are good collateral. This type of secured loan is called “repo,” and it is a big standardized market with low interest rates that lots of cash investors participate in.

You could imagine another way of doing the trade. [2]  You could imagine a bond manager saying “I would like to own Treasuries but not put up a lot of cash, so I am going to go across the hall to the money market fund manager at my firm and ask him to lend me the money to buy the Treasuries.” This is not the norm, in part because a lot of bond managers aren’t supposed to borrow money but are free to use futures. (This is called “synthetic leverage”: It’s economically equivalent to borrowing the money to buy Treasuries, but it doesn’t technically count as borrowing.) A lot of asset managers will buy Treasury futures but won’t go to the repo market to borrow money to buy Treasuries. Instead, hedge funds will do it for them; they will package the leverage into the right synthetic format for the asset managers.

It is possible that this could blow up: The hedge fund has mark-to-market gains and losses on its futures and its bonds, which should mostly offset each other (the futures are just contracts for the future delivery of those bonds, and ultimately the hedge fund can close them out by delivering the bonds), but they can temporarily move apart and cause trouble. Plus the hedge fund has to post collateral on both sides, and the collateral requirements could change: If repo lenders get more nervous, the hedge funds will have to pay them back, which could require selling their bonds and unwinding the trades. This could lead to big price dislocations, and in March 2020 it did. People have been worried about it ever since.

Bloomberg’s Alex Harris reports:

The Federal Reserve should consider setting up an emergency program that would close out highly leveraged hedge-fund trades in the event of a crisis in the $29 trillion US Treasuries market, according to a panel of financial experts.

Any vicious unwinding of a swath of the estimated $1 trillion in hedge fund arbitrage bets would not only hamper the Treasuries market, but others as well — requiring Fed intervention to assure financial stability. When the US central bank did that in March 2020, during the initial Covid crisis, it engaged in massive outright purchases of Treasury securities, to the tune of about $1.6 trillion over several weeks.

A better way of stepping in would be via hedged bond purchases, according to a Brookings Institution paper by Anil Kashyap at the University of Chicago, Harvard University’s Jeremy Stein — a former Fed governor, Harvard Business School’s Jonathan Wallen and Columbia University’s Joshua Younger.

“If the Fed is tempted to buy again, we’d rather they do that on a hedged basis,” Stein told reporters in a briefing on the paper, which was released late Wednesday. This approach “can be a valuable addition to the policy toolkit” at the Fed, the authors wrote in the paper.

Here is Kashyap, Stein, Wallen and Younger’s research summary, and here is the underlying paper. From the summary:

Broker-dealers and, increasingly, hedge funds in essence lend their balance sheets to the asset managers. They directly hold the Treasury securities that the asset managers prefer to hold synthetically through derivatives. The hedge funds and broker-dealers hedge their direct holdings by taking a “short” position in derivatives (the opposite of the asset managers). If interest rates rise and the value of their direct holdings declines, then the value of their derivatives positions increases to offset the direct holdings’ decline. The dealers and hedge funds are compensated for this service through the spread, known as a “cash-futures basis,” between the returns on Treasuries and Treasury derivatives.

The vulnerability arises because the hedge funds, which are more lightly regulated than broker-dealers, finance their Treasury holdings almost entirely by borrowing against them. Thus, any number of shocks can lead the hedge funds to quickly exit the trade, requiring the broker-dealers to step in, at least in the short term.

The authors recommend that the Federal Reserve, in periods of extreme stress, be prepared to take over the hedge funds’ positions. As before, the Fed could stand ready to purchase Treasury securities but it would also, as the hedge funds do, take offsetting short positions in derivatives.

The primary advantage of that approach for the Fed, they write, is that the purchases would be self-liquidating because the reversal of the securities purchases would be embedded in the short positions in derivatives. The Fed would not, as it has had to do during the COVID-era, worry about how to reduce its holdings once market stress subsides. And, because the purchases would be hedged, the Fed would not have to take a loss on those holdings if it has to raise interest rates to quell inflation, as it did in the aftermath of the pandemic.

The Fed has plenty of experience lending against Treasuries in the repo market. This proposal is just for the Fed to do a bit more of the trade: Instead of lending against Treasuries, it would buy the Treasuries and also sell the futures. It’s economically pretty much the same thing, though: The Fed can print money, and it can lend its balance sheet to levered investors so they don’t all have to dump their Treasuries at once. The Fed is the lender of last resort in the US financial system, and in modern finance that means being the synthetic lender of last resort. 

In possibly related news, Bloomberg’s Yizhu Wang and Weihua Li report:

One of American banks’ fastest-growing businesses is lending to the very companies trying to grab their market share.

Traditional bank lending to non-bank financial institutions like private equity firms, hedge funds and private credit shops more than doubled in the past five years, according to data analyzed by Bloomberg. That 16% annualized rate far surpassed their lending to categories including agriculture, credit cards, commercial and industrial companies as well as foreign governments, the data show.

The phenomenon underscores the seismic shift taking hold in US finance, where less-regulated lenders have stepped into a void opened up after the financial crisis prompted banks to slow certain types of lending. As those firms proliferated, traditional banks eager to capture the spoils have gotten in on the action, with lending to companies often dubbed shadow banks hitting $1 trillion last year.

“The banks are caught in a weird dance,” said Brian Foran, who covers bank stocks at Truist Securities Inc. “In effect, banks are financing their own competition.”

You know my take on this. If you are a bank and you are losing leveraged buyout financing business to private credit firms, or losing trading business to quantitative proprietary trading firms, and those firms come to you and say “hey we need to borrow some money to keep taking business away from you, want to lend it to us?” you might reasonably be annoyed, but you are wrong. You shouldn’t be lending to LBOs, or doing securities trades. It is a historical accident that banks do that, with their rickety funding model backed by demand deposits. That stuff should be done by nonbank firms with long-term locked-up equity funding. But not exclusively equity funding. Some equity funding, and some debt. Where do they get the debt? Well, from banks! Banks should invest in safe assets, which means not directly doing the stuff they used to do (lending to LBOs, securities trading), but rather lending against that stuff, letting someone else do the stuff and taking senior claims on their activities.

This is overstated in various ways: Of course banks should do LBO lending and securities trading, I’m not a monster, and of course lending to private credit firms is not perfectly safe. But there does seem to be a trend: Banking is getting incrementally narrower, and nonbank financial firms are increasingly getting into businesses that 20 years ago were done by banks. Those firms take the first-loss risk on that business, and banks lend to them and get some more cushion from losses. 

Also I should say that my model of “the nonbank financial institutions are funded with long-term locked-up equity, not like the banks and their deposits” is pretty idealized. I think it is a roughly correct description of private credit: Private credit firms do borrow money from banks (and from bond markets), but they are basically more equity-funded and less flight-prone than banks are. But not everything in the “nonbank financial institutions” category is like that. The essential fact about nonbank financial institutions is that they are not regulated like banks. Sometimes their funding model is naturally safer than that of banks, but that’s not guaranteed. If you are a hedge fund running basis trades at 18 times leverage using overnight repo, in some sense your funding model is riskier than a bank’s — that’s why the Fed is thinking about how to bail you out! — but you are not regulated like a bank. Some of the trend is toward narrower banking, but some of it is toward more shadowy banking.

Anyway, the new narrower banking is still a fine business for banks:

One Providence, Rhode Island-based lender says it’s benefitting from the shift. Citizens Financial Group Inc. has more than doubled its roster of private equity customers to 175 since 2014, according to Chief Executive Officer Bruce Van Saun. Many of those clients expanded into private credit using financing from Citizens, which they lent to their portfolio companies, he said in an interview.

“We’re making more money from the growth in private credit than we’re losing in direct head-to-head competition with them,” Van Saun said.

Perhaps investing firms, like social media companies, are generational. In the olden days, when young people graduated from college, their parents would take them down to the local full-service broker and buy them their first 100 shares of Amalgamated Spats preferred stock, and as their fortunes grew the broker took care of all their needs. But their kids were on the internet, and the idea of walking into a fusty old full-service brokerage (and paying high commissions) was off-putting to them, so they opened accounts at E*Trade or Charles Schwab. These accounts were small and not very lucrative, but over time those kids grew up, and they got more money and needed more financial services, and the discount brokerages grew up with them.

Their kids, though, (1) get their internet from phones, not computers, (2) want investing to feel like a video game and (3) don’t want to pay any commissions at all. So Robinhood Markets Inc. launched and got a lot of customers with free, phone-based, gamified stock trading. That looks in various ways like sort of a downscale business — a lot of those accounts are small, and they get smaller by gambling on meme-stock options — but those kids grow up too and need retirement advice. It is possible, I have written, “that day trading meme-stock options is a gateway drug for sensible retirement investing.” Also for on-demand helicopter rentals though. The Wall Street Journal reports:

Robinhood, the digital brokerage that channeled the meme-stock and crypto craze, is angling to keep its youthful clientele as they graduate from YOLO investing to estate planning.

The company said Wednesday it plans to roll out many new services, from wealth-management tools and bespoke investment portfolios to bank accounts. All of them cater to Americans as they age, earn more money and navigate more complicated financial lives. Robinhood customers’ median age has climbed to 35 years old from 31 over the past five years. 

As it did with its brokerage, Robinhood is leaning into the ubiquitous presence mobile phones play in the lives of consumers. Some of its new offerings are more likely to appeal to a younger crowd; the perks planned for bank account holders include discounted helicopter rides and home deliveries of cash that are as easy as ordering a meal on DoorDash. 

The world is “moving from people who grew up needing stockbrokers and visits to bank branches to the type of people…who are growing up with the tools to independently manage their finances from home,” Vlad Tenev, Robinhood’s chief executive, told investors at an event late last year. “We’re uniquely positioned at the epicenter of this massive cultural and financial shift.”

I mean, that’s right, right? Robinhood made a big, somewhat messy bet that the kids these days wanted to do fun trading on their phones. That bet turned out to be correct, and the two main ways for it to pay off are:

1. Robinhood gets to sell them even more ridiculous high-margin bets: single-stock zero-day options! sports betting! so much crypto!
2. Those kids grow up, get more money, and need high-margin wealth and investment advice (and helicopters). They trust and are familiar with Robinhood, so it is well positioned to sell them that advice.

I am not sure which effect predominates in the long term, but Robinhood can certainly try both. There is some cognitive dissonance when the same app on your phone is offering you both retirement planning and sports gambling, but maybe “total comfort with cognitive dissonance on your phone” is what distinguishes today’s 35-year-olds from, you know, me.

What about their kids? If you are graduating college today, do you think Robinhood is for old fogeys? Where do you put your first $100? What is the platform that you use for fun now, that will grow up with you, that will surprisingly be offering retirement planning in 10 years? Is it FanDuel? Is it Pump.fun? Am I a huge boomer for even suggesting those names? Is it something I’ve never heard of? Almost certainly.

My model used to be that investment banks were socialist paradises run for the benefit of their workers, but that is increasingly untrue. The Financial Times reports:

HSBC fired investment bankers on the day they were due to learn their bonus figures and gave no bonuses to many it let go, in a sign of how the bank is taking a more ruthless approach to costs under new chief executive Georges Elhedery. 

The London-based lender told staff in its UK investment banking business last month that they were losing their jobs, having said in January it would shut its mergers and acquisitions advisory work and its equity capital markets business outside of Asia and the Middle East. 

Those conversations took place just as bankers expected to learn how much they would receive in bonuses for work done in the calendar year 2024, three people with knowledge of the matter said. But bankers at vice-president level and above within HSBC’s investment banking unit who had their employment terminated as part of the restructuring received no bonus, the people said.

“It’s very unlike HSBC,” one of the people said, adding that the bank had “a reputation for looking after [its] people”. The bank declined to comment.

Other investment banks sometimes pay bonuses to those whose positions they terminate as part of restructuring programmes, even if such bonuses are smaller than usual.

Yeesh! I get it: If you are getting rid of all of your investment bankers, why would you pay them bonuses on the way out the door? You don’t need anything else from them, and while zeroing the people you fire might be bad for the morale of the people who stay, if you’re firing everyone, that doesn’t matter. Traditionally investment banks try to avoid this, because they are run by investment bankers who tend to look out for the interests of investment bankers as a class. But increasingly investment banks are run like coldly rational profit-maximizing public companies, which sometimes involves stiffing the investment bankers.

Endeavor Group Holdings Inc. was taken private on Monday by its biggest shareholder, Silver Lake, for $27.50 per share in cash. Last Friday, Endeavor’s stock closed at $29.25 per share on heavy volume. Everyone knew the merger was closing on Monday. Why did the stock trade above the deal price? The answer is probably that if you bought the stock on Friday, you were getting (1) a fairly certain $27.50 per share on Monday plus (2) your share of a potential shareholder lawsuit against Silver Lake arguing that the deal was unfair and the price should be higher. On Friday, the market valued that lawsuit at about $1.75 per share.

That is an approximate analysis, and the lawsuit does not really trade separately from Endeavor stock, which means that, like the stock, the lawsuit stopped trading on Monday morning. But if it was still trading I think it would probably be up today, because yesterday Icahn Enterprises LP disclosed that it owned 8.4% of Endeavor’s stock as of Friday. [3] If a big famous investor announces a big position in your stock, that stock tends to go up; presumably part of the reason that Endeavor’s stock went up on Friday was just Icahn’s buying pressure. But the main point today is that Carl Icahn has taken a position in the lawsuit: The most likely reason for him to be buying Endeavor stock in size last week was that he wants in on a lawsuit against Silver Lake. If you are also in the lawsuit trade, that is presumably good news for you, [4] because:

1. Icahn is a smart successful investor and his interest arguably validates yours, and
2. Icahn is cantankerous, and at the margin it seems like he’d pursue a lawsuit vigorously and make life unpleasant for Silver Lake. You want him on your side in something like this.

Man, GameStop is really doing the whole Strategy playbook:

GameStop Corp. is seeking to sell $1.3 billion of convertible bonds to fund Bitcoin purchases as it embraces a strategy that was developed by the cryptocurrency advocate Michael Saylor.

The video-game retailer rallied after the company said on Tuesday that its board approved a plan to add Bitcoin as a treasury reserve asset. That was followed on Wednesday by a filing announcing the planned sale of the bonds, which will be used for general purposes, including the acquisition of Bitcoin.

The Grapevine, Texas-based GameStop joins a growing list of public companies taking on convertible debt to buy Bitcoin in an attempt to capitalize on upswings in the cryptocurrency. The tactic was pioneered by Saylor’s Strategy, the enterprise software company formally known as MicroStrategy, which has acquired more than $40 billion in Bitcoin and seen its share price soar. …

GameStop’s entry into the market comes even as investors appear to be growing more skeptical of the strategy.

I think that the three main elements of the Strategy strategy are:

1. Buying a lot of Bitcoin,
2. Getting retail investors to pay attention to you, and
3. Having a volatile stock.

The first element is straightforward. Strategy achieved the second element in part by being early to the corporate-treasury Bitcoin trade and in part by Saylor being very vocal about it, but GameStop can obviously achieve the second element by being GameStop. (There are multiple movies and TV series about how much attention retail investors pay to GameStop.)

The third element is perhaps the subtlest and the least essential, but Strategy has raised a lot of money by selling convertibles, and convertibles are essentially a way to package and sell volatility: The more volatile the stock is, the more valuable a convertible is to arbitrage investors, who hedge the convertible by buying stock when it goes down and selling it when it goes up. Strategy’s stock is extremely volatile, in part because it is a meme-y Bitcoin investment vehicle and both memes and Bitcoin are pretty volatile, but in part because a lot of its stock is owned by levered exchange-traded funds that buy more stock when it goes up and sell when it goes down. The levered ETFs create volatility, which the convertibles consume, and Strategy sits in the middle collecting money.

GameStop is not quite as volatile as Strategy these days but, you know, it’s GameStop. It can ramp up the volatility any time it wants. Get Roaring Kitty to tweet a picture! Announce a Bitcoin treasury strategy! 

OpenAI Close to Finalizing $40 Billion SoftBank-Led Funding. CoreWeave Is Planning to Cut IPO Size to $1.5 Billion. Delaware Punches Back at Texas Efforts to Lure Away Companies. Apollo president says private credit is ‘not a bubble.’ Vanguard Met With Blackstone, Carlyle on Private Markets Product. European oil traders weigh Russia return in market reshaped by war. U.S. Prosecutors Probe Tip About Timing of Pfizer Vaccine. JPMorgan Says Quantum Experiment Generated Truly Random Numbers. Lufthansa Shakes Up Business Class With Seven Seat Categories. “If you’re the average Wall Street employee, it is no time to run out and buy your Hamptons home.”

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