The Capital Note

Pandemic Post-Mortem

A man wears a mask as he walks past the New York Stock Exchange in New York, March 13, 2020. (Lucas Jackson/Reuters)

Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: post-mortem on the Treasury market meltdown, PPP problems, the end of the CARES Act, and the rise of carry.

Pandemic Post-Mortem

As COVID-19 began its spread across the United States, the deepest and most-liquid financial market in the world — that for U.S. Treasury securities — experienced a near meltdown. At first, a flight from risk caused Treasury yields to spike, but demand for U.S. government debt soon dried up as corporations and investors sold off whatever they could to shore up their balance sheets with cash.

Treasury markets experienced unprecedented illiquidity, as sellers demanded higher prices than buyers were willing to pay. Treasuries, typically seen as near-substitutes for cash, were suddenly trading at spread usually associated with corporate bonds. The Federal Reserve soon initiated massive asset purchases to maintain market functioning. Soon thereafter, regulators and commentators identified a culprit for the dysfunction: hedge funds.

Relative-value hedge funds hold large, levered positions in Treasury securities while selling corresponding futures contracts. Traders employing this strategy profit from the small difference in yield between the two securities.

In an April paper, economists at the Bank for International Settlements detailed the amount of leverage associated with this trade:

Relative value investors can achieve high levels of leverage because the collateral value of Treasury securities is normally high. For instance, if an investor can borrow $99 by pledging $100 worth of treasuries, the investor need have only $1 of own funds to hold treasuries worth $100, achieving 100-fold leverage. In this way, even a small yield difference can be magnified by leverage. Before the Covid-19 crisis, the cash futures relative value strategy delivered a steady stream of returns.

As markets sold off in March, yields on Treasury futures dropped more rapidly than their corresponding cash securities, imposing massive losses on relative-value hedge funds:

Futures-implied yields dropped more rapidly than bond yields, imposing mark-to-market losses on relative value investors who had sold futures and bought cash bonds . . . Once the funds were no longer able to meet variation margins, their positions were unwound by dealers/futures exchanges, pushing prices lower. This in turn gave rise to a classic “margin spiral”…whereby the cycle of illiquidity, price dislocations and tighter margin requirements fed on itself.

The view that hedge funds exacerbated financial-market stress has become commonplace, but a new paper by Harvard Business School professor Marco Di Maggio casts doubt on that theory. For one, Di Maggio explains, relative-value hedge funds comprise only a small part of the market for Treasuries.

Because these funds constitute roughly 9 percent of the weekly trading volume in Treasuries, their sales alone are unlikely to have had such a dramatic effect on prices. And liquidity in the specific securities traded by relative-value funds (called “cheapest to deliver”) held up quite well during the COVID-19 sell-off when compared with other securities in the market.

The more likely culprit is a lack of liquidity from banks, due in large part to capital requirements established after the 2008 crisis — precisely the kinds of rules that regulators will be calling for post-pandemic.

Around the Web

The end of the CARES Act:

Treasury Secretary Steven Mnuchin said he does not plan to extend several key emergency lending programs beyond the end of the year, a decision that could hinder President-elect Joseph R. Biden Jr.’s ability to use the Federal Reserve’s vast powers to cushion the economic fallout from the virus.

Buzzfeed acquires HuffPost:

The acquisition is part of a larger deal between BuzzFeed and Verizon Media, a unit of Verizon Communications Inc. Under the pact, the companies will syndicate content on each other’s platforms and look to jointly explore advertising opportunities. Verizon Media will get a minority stake in BuzzFeed as a result of the tie-up, the companies said.

More PPP problems:

In a joint statement Thursday, Senate Finance Chairman Chuck Grassley and Democrat Ron Wyden said the Treasury is depriving some small businesses of much-needed economic relief by forcing them to choose between getting their PPP loans forgiven or claiming write-offs on expenses they covered with the loan money.

Random Walk

As we debate the role of hedge funds in financial stability (or lack thereof), today’s Random Walk takes us to a recent book by Tim Lee, Jamie Lee, and Kevin Coldiron. The authors of The Rise of Carry argue that increased volume in “carry” trades — in their words, trades that “make money when ‘nothing happens’” — have exacerbated financial crises. A relative lack of risk leads investors to borrow great sums against their positions in carry trades. The authors explain:

The use of leverage means that hedge funds control far more securities than represented by their AUM. This was most dramatically illustrated in 1998 when Long Term Capital Management (LTCM), the gold standard for hedge funds at the time, collapsed spectacularly. Entering that year, LTCM managed just under US$5 billion, but with an estimated leverage of 25 to 1, it controlled securities worth US$125 billion.

Leverage not only multiplies the assets under a hedge fund’s control; it also directly reduces its margin for error, in turn making the portfolio much less stable. Even a relatively small loss on a highly levered portfolio can trigger a margin call. To meet the margin call, positions must be liquidated, often in adverse market conditions, and a vicious circle of forced selling can be trigged. In other words, the US$125 billion of securities controlled by LTCM was vastly more unstable than that same amount under the control of a traditional investor. While LTCM’s use of leverage was extreme, the same principles apply to any levered portfolio; both its influence on markets and its instability, particularly during bad times, are increased . . .

The combination of leverage and frequent trading makes hedge funds even more influential than their headline AUM would suggest. If this headline AUM has grown by 25 times in the last two decades, then hedge fund influence on markets has increased by an even greater magnitude. Given structural incentives to be long carry, it is no surprise that the last two decades have also seen a similar increase in the scale and impact of carry on global markets.

— D.T.

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