Broken Hedges

Peter Tchir wrote a piece yesterday describing yet another hole in the banks’ balance sheets:

I am not sure I fully understand it, but to me it looks something like this:

A bank has a duration mismatch. Its funding is short-term, which means it must be rolled over frequently. This subjects the bank to the risk of a rise in interest rates, which would make its cost of funding higher. And of course if rates rise, then the market value of the bond it bought is lower.

So when they go to buy a new bond, they also buy an interest rate swap. The calculus is as follows:

1) if interest rates fall, their funding will get cheaper (a gain), the bond they bought will go up in value (a gain), and the swap loses value (a loss);

2) if interest rates rise, their funding will get more expensive (a loss), the bond will go down in value (a loss), and the swap will rise in value (a gain)

By calculating the amount of swaps to buy, the bank thinks it is controlling its risk. The bank wants to make a pure spread: Interest on bond – funding cost – swap cost.

But today as Mr. Tchir writes, the problem is that the bond is losing value not because rates are rising but because the issuer is in trouble. So the swap is not providing the protection that the bank hoped for. The bank’s funding costs may or may not be falling, but it is certainly taking a loss from the fall in the price of the bond due to credit risk and a loss due on the interest rate swap as well.