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LTCM ReduxA 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%. Meanwhile, remarkable changes in the market for inflation-protected bonds, known as TIPS, meant that real interest rates moved from negative to positive and back again in the space of barely more than a week. 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:
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.  Other technical factors came into play. Risk parity hedge funds had been among the most successful in recent years, and suffered some dreadful losses as the bond market took its dive. The concept is to scale up leverage on the less risky bonds side of a balanced asset allocation. It works beautifully unless both stocks and bonds start to fall at once, which they did last month. This caused more forced sales. Hedge funds were increasingly raising funds via the repo market (borrowing short-term using bonds as collateral). This made them that much more vulnerable to shifts in short-term funding, as happened last month.  The Fed’s intervention seems to have dealt with the risk of total meltdown, which appeared very real for about two weeks in March, and that is one of the reasons behind the rally in stocks. Many worries remain, and they are probably being underestimated at present, but the risk of a financial disaster has been countered, and it also looks as though the risk of an all-out public health catastrophe in New York, with hospitals overwhelmed, has also been averted. This doesn’t mean, however, that all is rosy in the bond market. We have just had proof that it isn’t. 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. The BIS also concludes that the sudden seizure of the repo market in September last year was a “canary in the coal mine.” It was driven by repo demand from hedge funds desperate to maintain arbitrage trades between cash bonds and the derivatives linked to them — and forced the Fed into the big expansion of its balance sheet now widely known as “Not QE.” History repeated itself. Last month the Fed stabilized the market through rapid buying of about $670 billion of securities that were burning a hole in dealers’ inventories. But there are other issues to confront. The base of investors in Treasury bonds is now less from “official sector” investors in central banks and sovereign wealth funds, or from long-term investors such as pension funds, and more from leveraged traders. That has probably made the bond market more accident-prone. As it is still probably the world’s most important market, central banks and regulators will have to find a way to deal with the new reality. And that is irrespective of the coronavirus scourge.
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