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From TIPS v Treasuries: What a wild ride it was!

Receiving 5% on one US Government Bond and paying 2.5% on another US Government Bond with the same maturity is an obvious winner, but many hedge funds went bust in 2008 because they were unable to hold their trades to fruition.

Emphasis mine

I am confused about why holding the trade is difficult. Is it because the they couldn't keep making the payments for the shorted treasury?

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When the bust came in 2008, hedge funds were force to settle out liquid positions (such as treasury bonds) in order to raise cash in order to meet margin calls on their illiquid positions.

These hedge funds would have been sitting on large positions in collaterallized debt obligations (specifically mortgage backed securities) for which there was suddenly no market (no buyers at any price). With no market, as the prices of these CDOs collapsed the margin requirements would have soared. With insufficient cash on hand to meet the margin calls, they would have been forced to sell their most liquid assets.

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  • Ah okay. I was confused because I read that as in general when fixed income arbitrage are held it is difficult to hold to fruition, but rather it was difficult in 2008 because of the forced liquidation. Makes sense.
    – user32205
    Sep 23, 2019 at 20:36
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    The trade in the link was about arbing TIPS v Treasuries. It was not about CDOs and it's an assumption that this arb failed because of losses in other positions (CDOs).
    – Bob Baerker
    Sep 24, 2019 at 0:24
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Receiving 5% on one US Government Bond and paying 2.5% on another US Government Bond with the same maturity is an obvious winner, but many hedge funds went bust in 2008 because they were unable to hold their trades to fruition.

I don't know this market so I can't explain what happened to this trade back then. But having done many, many equity pairs trade in 2008-2009, I can spell out some of the issues in a such long-short arbitrage.

1) You pay out the yield on the short position. This isn't a problem if you're shorting the low yield and buying the high yield.

2) You pay out the borrow rate on the short position. It can be nominal or if there's an extreme amount of subsequent shorting, it can rise significantly.

3) When there's panic (see 2008), brokers can increase the margin rate, requiring more collateral.

4) If the pair isn't highly correlated and market participants rush to buy your short leg (flight to safety?), price diverges and your collateral requirement increases.

Now imagine the guy (or firm) that is margined to the gills and some combination of these events increases his margin required. He can't sustain the trade. The paragraph following your excerpt states:

We hold about 50% of our fund as unencumbered collateral, precisely for situations like this. At our low point (end of October 2008), we still held 36% of our fund as excess collateral. We were able to hold this trade through the chaos. Despite entering the trade way too early and suffering initial losses as well as losses from other trades around the world, our collateral was sufficient to maintain our positions.

It required 14% of their collateral to hold onto the trade. The over margined guy was toast.

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  • "You pay out the borrow rate on the short position. It can be nominal or if there's an extreme amount of subsequent shorting, it can rise significantly." Do you mean that they buy a short, and then after the fact something in the market changes and the broker comes back demanding more collateral?
    – user32205
    Sep 24, 2019 at 16:07
  • When you are short selling, you borrow stock from a lender in order to sell what you don't own. Your broker handles the borrowing of shares from an in house account or from another broker. There is an associated borrow cost for borrowing the shares. For example, right now at my broker, the borrow rate for NFLX is 0.25% which is peanuts. . In January of this year, the borrow rate of TLRY soared to 900%. That's a chunk of change. How do you carry that trade when they're sucking out 2.5% of the value of TLRY in cash from your account every day?
    – Bob Baerker
    Sep 24, 2019 at 16:21
  • Can the borrow rate change mid trade? For example, I short NFLX today, but can my broker start pulling 0.5% tomorrow if something changes? Naively I would have expected it to be locked at the beginning of the trade.
    – user32205
    Sep 24, 2019 at 16:47
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    The borrow rate can change daily and you are charged that day's borrow rate each day. Note that a borrow rate of 0.25% is the annual rate so it's (stock price) x (borrow rate) /365 per day. On Monday, you are charged for 3 days (the weekend). My broker accumulates the fee and deducts it from my account at the end of the month. I don't know if other brokers do the same or if they deduct it daily.
    – Bob Baerker
    Sep 24, 2019 at 17:42

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