WASHINGTON – As the coronavirus began shutting down the global economy in March, critical parts of the US financial markets came close to collapse. The impact was huge and unexpected, but the vulnerabilities were well known, the legacy of risk-taking beyond regulatory reach.
To avoid a devastating downward spiral, the Federal Reserve came to Wall Street’s rescue for the second time in a dozen years. As investors sold a wide range of holdings and rushed to comparative cash security, the Fed pledged to become a buyer of last resort to restore calm in critical markets.
That backing rescued many individuals and investment firms, including a class of hedge funds that had been caught on the wrong side of a high-risk operation. The history of that trade, how it went wrong, and how it was rescued, offers a warning story about important issues that Congress did not address in the 2010 Dodd-Frank financial law and the Trump administration’s regulatory approach.
A decade after Dodd-Frank, the overwhelming post-2008 crisis in America, became law, commercial banks such as JPMorgan Chase & Company and Bank of America are better regulated and safer, but may be less willing to help smoothing markets in times of stress Tighter regulation in the formal banking sector has brought risk-taking to the dark corners of Wall Street, areas that Dodd-Frank largely left intact.
Additionally, the powers of policy makers to deal with persistent vulnerabilities have been undermined by Trump administration officials who came into office seeking to weaken financial rules. Treasury Secretary Steven Mnuchin, who heads a panel created by Dodd-Frank to identify financial risks, moved to free large financial firms from oversight and left an Obama-era task force that was examining the risks of hedge funds.
The result is a still fragile system, in which financial actors make a profit in good times, but the government is forced to save them or let the economy suffer when things go wrong.
“It is very dangerous to have a regime where you know this can happen,” Janet L. Yellen, the former president of the Federal Reserve, said in an interview. “The Fed did incredible things this time.”
Trusting the central bank to save the day is not a long-term solution, he said. There is no guarantee that the Fed and the Treasury Department, which must provide the money to support many of the central bank’s emergency programs, will be as aggressive in the future.
Hedge funds are a risk that is not addressed. Some regulators have warned for years that a certain type of hedge fund, so-called relative value funds, could struggle in a stressed market. Authorities also warned that they could not say how great the risk posed by those funds was because they did not have enough information about their operations and how much money they were borrowing.
Of particular concern: Hedge funds were using business strategies similar to those employed by Long-Term Capital Management, a fund that collapsed in 1998 and nearly caused a financial collapse.
The hedge funds’ bet earlier this year was pretty simple. Called a base trade, it involved exploiting a price difference in the Treasury market, generally selling Treasury futures contracts (promises to deliver a bond or promissory note at a fixed price on a given date) and buying relatively cheap underlying securities.
Hedge funds made a small return by converging the price of a security and its futures contract. To convert those small payments into real money, they turned to a form of short-term borrowing, called a repo, and used it to build up huge holdings of Treasury bills. Such exchanges are often incredibly leveraged.
The problems started when the markets became very volatile in mid-March. Funding for the essential repository for operations was suddenly difficult to come by as the financial institutions providing the loans withdrew. Historical price patterns were broken, and many trades were no longer profitable. Some hedge funds were forced to get rid of government debt
Banks could have acted to alleviate stress by buying stocks and finding buyers. But they already had a lot of government bonds, and could no longer manage in part due to regulations established after 2008. They all sold: ordinary investors, foreign central banks, and hedge funds. Hardly anyone was buying.
The United States government debt market, the core of the global financial system, was stagnating.
“The serious dislocation in one of the most liquid and important markets in the world was surprising,” wrote the Bank for International Settlements, a bank for central banks, in its annual report last month.
The Fed stepped in to prevent a catastrophe and pledged during an emergency meeting on Sunday afternoon to buy large sums of government-backed bonds.
It is unclear how important the role hedge funds played in the March crisis, including how many and what funds were involved remains unclear. The funds are not required to disclose detailed data on the size of their bets and exactly what and when they sold. According to information from the Bank for International Settlements, the development of relative value was a “key driver” of the turmoil.
Researchers writing for the Treasury Department’s Office of Financial Investigation said in a report that base operations definitely went wrong in March and that some hedge funds sold their securities, but it is unclear how much sales affected the market liquidity of the Treasure. Still, the report acknowledged that Federal Reserve intervention could have avoided more serious consequences.
Michael Pedroni, executive vice president of the Managed Funds Association, which represents hedge funds, said in a statement that “a growing body of evidence” showed that “hedge funds could continue to provide some liquidity even when banks went bankrupt. they withdrew by providing financing “and that the funds were not a systemic risk.
While few had predicted the pandemic, many experts had long warned that the financial system was vulnerable.
Long before the crisis this spring, the Financial Stability Oversight Board, established by Dodd-Frank, had repeatedly identified hedge fund leverage as a risk. Under the Obama administration, he formed a hedge fund task force to consider the potential risks of many hedge funds employing similar trading strategies.
On November 16, 2016, the task force warned that hedge funds could be a source of instability during turbulent times.
“Forced sales of hedge funds could cause a sharp change in asset prices, leading to further sales, substantial losses or financing problems for other companies with similar interests,” Jonah Crane, deputy secretary to the group, told the group. attached to the council at that time. “This could significantly disrupt trade or financing in key markets.”
The task force recommended that regulators collect more information on hedge funds, including their operations, the type of granular data missing from fund managers filing with the Securities and Exchange Commission, known as the PF Form.
“Our recommendation was to arrange the PF Form so that we could obtain the underlying data,” said Mr. Crane, now a partner at consulting firm Klaros Group, in an interview. “These strategies we thought we saw looked a lot like long-term capital management strategies and suggested to us that at least one should know who was exposed to them.”
SEC President at the time, Mary Jo White, agreed with the recommendation. But with the arrival of a new administration, there was little chance of addressing the problem in the last few weeks of the Obama administration.
In early 2017, Mr. Mnuchin, a former hedge fund manager, took over the Financial Stability Oversight Board and the hedge fund working group was deactivated.
Richard Cordray, who was on the board as head of the Office of Consumer Financial Protection from 2012 to November 2017, said that once Mr. Mnuchin took office, the discussion turned into relaxed supervision.
“It was clear from the beginning that I wanted to move FSOC in a different direction, that it was a deregulatory direction,” Cordray said.
A Treasury spokeswoman said the council “continues to monitor hedge funds as it monitors all sectors of the financial system.”
Relative value funds were not the only financial vulnerability exposed in March. The money market mutual funds, bailed out in 2008, required another bailout. Corporate bonds faced a wave of foreseeable downgrades. That market stagnated, prompting the Fed to make its first effort to buy debt from large companies.
Risks in lightly regulated financial companies “were not only predictable, but well documented,” Lael Brainard, the Fed’s governor, said at a University of Michigan and Brookings Institution conference in late June. “Now we have seen not once, but twice in just 11 years” risks that were deemed highly unlikely to threaten the economy.
Ms. Yellen and other policymakers said Congress may need to hold regulators accountable not only for individual institutions but also for the overall security of the financial system. Only the Federal Reserve has a mandate for financial stability, and it applies only to banks.
“There was a failure at Dodd-Frank,” said Ms. Yellen. “Dodd-Frank gave FSOC the responsibility to deal with threats of financial stability,” but did not pass it on with the power to do much more than cajole other regulators. “For FSOC to be meaningful, it must have its own power.”
