Brilliant piece by John Authers, the veteran markets commentator formerly with the FT. John brings back memories of LTCM, the hedge fund which went belly up in the late nineties and how nothing really has changed since then. The S&P500 lost a staggering 33% in a little over 20 trading days and then back to technical bull market territory with a 25% gain in 13 trading days flat in what is clearly a never seen before steep fall and a sharp rise. Whilst the emergence of passive funds and algo trading have been blamed for the same, John highlights the role of the now too familiar villain that is leverage for this sort of amplified market movements with a special focus on the bond markets where the US treasury yield has seen unprecedented levels. From LTCM to the sub-prime mortgage crisis to Covid, the role of leverage in asset markets has only risen as regulators have only used lowering of interest rates followed by quantitative easing to douse these crises, which in turn fuelled another leverage driven asset rally only to be followed by another crisis. And this time is no different as the Fed along with other G-7 central banks has thrown another bout of QE adding up to $1.7trn in March alone putting to shame the previous QE high of a paltry $275bn in April 2009.
“A few weeks ago, I recommended When Genius Failed, Roger Lowenstein’s masterly narrative of the meltdown and rescue of Long-Term Capital Management in 1998, as one of five books to read in self- isolation. It is a great read, and I suggested it because it covers a crisis that was in many ways a rehearsal for the all-in disaster that would follow 10 years later. The interest rate cuts and coordinated bailout with which the Federal Reserve dealt with LTCM might even be seen as the crucial acts in stoking the moral hazard and over-confidence that gave us 2008.
I must confess that I didn’t recommend it as a description of what was happening currently in the bond market. But it turns out that genius failed again. The Bank for International Settlements has put out a fascinating report on events last month. These are the key takeaways: For a reminder, this is what happened to 10-year Treasury bonds during March: The 1% barrier had never been breached before, but once 10-year yields fell through that level, they were soon below 0.5%….Obviously, the market suffered some kind of an accident; there was no explanation for moves like this in the macro-economy.
Dealing with that accident didn’t come cheap. The bond market has returned to (relative) calm this month, but only after the Fed threw some $2 trillion at the problem, with a massive program of asset purchases that in scale equaled the first wave of quantitative easing after the Lehman bankruptcy.
It was far more costly than LTCM: The BIS researchers suggest the problem started with hedge funds taking on too much leverage to bet on what should have been simple market discrepancies. This is exactly what happened at LTCM: taking a long position in one security and a short position in another and then leveraging it up many times.
The problem arises with feedback loops. In an orderly market, sales tend to beget buys by others, who see that a price has fallen too far. But in extreme conditions such as in early March, sales force funds to deal with redemptions and lead to further sales. As the BIS researchers put it: One example is when an investor has borrowed money to purchase assets. When the asset price falls and threatens the investor’s solvency, the lender will call in the loan, forcing the investor to sell. In this way, a price decline can lead to further sales, not purchases. Without dealers who can absorb sales and stabilise prices, a feedback loop may develop where price declines beget more sales, leading to further price declines.
As people grasped how severe the Covid-19 shock to the economy would be, this appears to have been exactly what happened. One “tell” of this is the gap between yields on Treasuries (which take up room on an investor’s balance sheet), and equivalent swaps (which don’t). The widening of this gap in mid-March showed that investors were desperate not to use up space on their balance sheet:
Meanwhile, funds had sharply increased the leverage they had taken on. This was decreasing slightly by the end of 2019, but the BIS shows that leverage had risen at a startling rate through 2018 and early 2019 (and appeared unaffected by the major market breaks in February and December of 2018): So a lot of hedge funds were caught with over-leveraged positions that turned bad. (This happened to LTCM.) This became more of a systemic incident because of another problem, with the supply of bonds. The number of primary dealers in the system has reduced since the last crisis, largely as an unintended consequence of post-crisis re-regulation. But supply of new bonds from the Treasury has been heavy for the last two years. Following the tax cut at the end of 2017, the government has a much bigger deficit to finance, while the Fed was for much of that period adding to the number of bonds in the system as it reduced its balance sheet. That left primary dealers with far more bonds on their hands than they wanted, and therefore more reluctance to step in as buyers of last resort.
…So what should happen now? A lot of the BIS recommendations sound similar to proposals for reform that followed the last crisis, so it is depressing they haven’t been made. Market monitoring, the authors say, should look beyond the present and ask “what-if” questions. If stress tests are to be effective, they must look at the possibility for negative feedback loops and forced sales “especially in tranquil periods when leverage is building up”. In other words, regulators still hadn’t learned the lessons of Hyman Minsky, also very much in vogue and well aired at crisis time, that stability tends to create instability.”
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