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Christopher Leonard is a business reporter whose work has appeared in The Washington Post, The Wall Street Journal, Fortune and Bloomberg Businessweek.
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LET THEM EAT ASSETS...CHAPTER 13 THE INVISIBLE BAIL OUT 2019-2020.... This bail out was unprecedented, and it benefitted a small group of hedge funds that had essentially hijacked the repo market and used it as a vehicle to make risky bets. The Feds saved them from the consequences of those bets...
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At 9:05 on the morning of Friday, September 13, 2019, a group of financial traders and analysts gathered for their regular daily meeting at the New York Federal Reserve Bank. These traders were expected, every weekday, to have a firm grasp of what was happening in global markets so that they could explain it to their boss, Lorie Logan, who oversaw the New York Feds entire trading floor. After everyone got settled that morning, the New York traders described what had them worried. They had been watching the enormous global market for the U,S, dollars, which they referred to simply as "money markets" The money markets tracked the flow of real actual, hard cash as it circulated around the world.
There were many parts of this market, including overnight loans that banks used to keep their books straight, along with the billions of dollars borrowed daily by hedge funds to finance their bets. The New York Fed was obsessed with global money markets. The Fed's primary job was to control the price of money, and this price was expressed in the short-term interest rates paid by the banks and hedge funds. The Fed's traders were worried that there might be a cash squeeze looming on the horizon. It was trued that the world was awash in cash, perhaps more cash than existed at any point in history. But the traders were seeing market signals indicating that short term interes rates were rising, and they might continue to do so, maybe sharply.
The Fed itself was directly responsible for the situation. The strain on financial markets was happening as a direct result of the normalization process overseen by Jay Powell. Normalization had been taken off autopilot, and had been essentially halted but the Federal Open Market Committee (FOMC) had none the less withdrawn some of the extraordinary interventions of the Bernanke era. When the Fed reversed quantitative easing, it drained more than $1 trillion of excess cash out of the banking system. Excess bank reserves ---meaning the level of cash that banks kept in vaults inside the Fed--had been drawn down from 2.7 trillion in 2014 to about 1.3 trillion in September 2019. This was still about 76,000 percent more excess bank reserves than existed in 2008. But the reduction was significant.
The warning signs were coming from the crucially important cash "repo" market. The repo market was part of the bedrock of the financial world, and it was supposed to be a super-safe form of lending. A repo loan was short term, maybe as short as overnight. It always worked the same way: A borrower would hand over Treasury bills in exchange for cash. Then, the next day or the next week, the borrower would give back the cash in return for the Treasury bills, paying a very tiny fee for the transaction. THe whole point of a repo loan was to be able to get cash when you needed it, in exchange for ultrasafe Treasury bonds. This was very important for Wall Street firms---they had hard assets like Treasury bills, which were worth a lot, and they needed ways to unlock the value in the form of cash to meet their overnight obligations. Banks were more than happy to do this short-term loan because it was safe; the banks held on to the Treasury bills as collateral so there really wasnt any risk. If the borrowers went belly-up, the bank could sell the Treasurys and recoup the total value of the loan. This is why the repo loan market was a muti-billion dollar market. All kinds of financial institutions used it every day to swap Treasurys for cash, so they had money on hand to do daily business.
On Friday the thirteenth, however, the repo market was sending out flashing signals. There were early signs that big banks like JPMorgan were increasing the very tiny interest rates that they charged for repo loans, banks were raising rates because they were growing hesitant to extend repo loans. The banks seemed to feel that they were running too low on cash reserves. On the following Monday the banks would be running extra low on cash because two things would happen at the same time. First, it was Tax Day for big corporations, which meant that banks would be sending a lot of cash out the door to pay tax bills. Second, a lot of auctions for U.S. Treasury bills were going to settle, meaning that banks had to pay cash for Treasury bills they had earlier agreed to buy. All of this would drain cash from the system and reduce the level of excess reserves.
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The events of the following Monday showed that the Fed's of New York trading team was essentially flying blind. This meant that the entire leadership team of the Fed, including Jay Powell, was also flying blind. The central bank had transformed the financial landscape by swamping it with money and in doing so had destroyed one monetary regime and replaced it with a new one. But there was no reliable instrument to measure the terrain of the new regime. This fact was made a stark reality on Monday, when the repo market blew up, the resulting market crisis almost became a full fledged financial crisis, at a moment in history when the markets were supposed to be stable and in good health. The only reason this didn't happen was that the Fed stepped in, almost instantaneously and initiated a 400 billion bail out. This bail out was unprecedented, and it benefitted a small group of hedge funds that had essentially hijacked the repo market and used it as a vehicle to make risky bets. The Feds saved them from the consequences of those bets. But the most remarkable part of the bailout is that the Fed did it without much notice. A 400 billion emergency cash injection was no longer news. The Fed described it as a matter of normal maintenance. But thats not how it looked from inside the Fed, as the repo market melted down.
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It wasnt unusual for repo rates to rise about 0.3 percent in times of stress. In December 2018, for example, the repo rate spiked dangerously during the market turmoil that prompted Jay Powell to reverse the normalization process. At the time the rates had jumped alarmingly high, from about 2.5 percent to over 3 percent . Nobody was expecting that much movement in September, when markets were tranquil, unemployment was low, and the economy was growing. The New York desk sent an alarming dispatch repo rates continued spiking, they would hit five percent that day. Nobody knew what was going on, this was the kind of repo rate that signaled a market panic. But there was no discernable reason for a panic. No bank had gone bust, no nation had just defaulted on its debt, and no major news had come out of a central bank . The analysts in New York were trying to get a handle on why the rates were spiking. It quickly became clear that the turmoil was not a fluke. The market was deteriorating. Lorie Logan who oversaw the New York Feds entire trading floor dispatched a message to Jay Powell , the repo market was seizing up, she reported , it wasnt stopping, and her team was simultaneously trying to understand the problem and come up with a plan to deal with it.
If the repo rates did not immediately subside from 5 percent back into a normal range between 2.25 and 2.5 percent, they could precipitate a cascading series of failures on Wall Street. All those hedge funds, that used repo loans to pay their daily bills would be forced to find other ways to raise cash, and raise it quickly. This meant they would start selling off hard assets, like Treasury bills or mortgage backed securities . When too many people do this at once, it creates a "deleveraging" event, meaning that everyone is liquidating their holdings at the same time, which causes prices to crash. Logan and her team worked until seven in the evening on Monday to get an accurate picture of the repo market, the situation was very bad, the repo panic was not abating. But even more worrisome, it looked like the Feds Funds rate was about to rise above the level set by FOMC.
On Tuesday morning Logan arrived early at the Eccles building to hold an emergency meeting with Powell, Logan presented the plan that her team had developed, if market conditions worsened, as the data seemed to predict, the Fed would be ready to act. That morning the price of a repo loan crossed 9.5 percent, this was the territory that caused financial meltdowns. That day the Fed initiated an unprecedented $75 billion into the overnight markets. That was just the start of a long bail out, which would later come to include massive new rounds of quantitative easing. When the Fed announced these measures, it used a lot of technical terms and talked about the whole thing as if it were a plumbing job. But this obscured and important reality. The money that the Fed unleashed was not a neutral force. It benefit some people and disadvantaged others.
Between 2014 and 2019, the total value of "short" positions in the Treasury futures markets owned by hedge funds rose from about $200 billion to nearly 900 billion. The hedge funds found themselves obligated to make payments on their future contracts but had to pay more money to keep the repo debt rolling. When repo rates spiked in mid-September, financial analysts on Wall Street started hearing alarming stories. Certain hedge funds were very very desperate to raise cash and raise it quickly. Ralph Axel, an analyst with Bank of America captured the moment in a report published months later, his message was chilling. He pointed out that the hedge funds dependence on repo loans had doubled in a decade. If the repo market was closed off to hedge funds, then they would be forced to liquidate Treasury bills and mortgage securities at a level twice as large as the amount liquidated in 2008. Always understand Axel wrote, "The impact could be massive" The financial world faced a forced liquidation event that could be twice as large as that in the horrific crash of 2008, and this was all happening during the apparently sunny weather of an economic boom, when markets were not just stable, but rising.
When the Fed entered the repo market on September 17, it bailed out any hedge funds that found themselves desperate for a repo loan. The going rate for such a loan was over 9 percent that day. The Fed offered such loans at 2.1 percent, using the money it could create instantaneously. The hedge funds could breathe. The repo market was once again available to them . It is difficult to quantify, financially, just how much money this was worth to hedge funds. They saved a great deal of money on the repo loan itself. But they saved a nearly incalculable amount by escaping the consequences of having entered basis risk trades that went bad. The Fed made sure the hedge funds did not need to liquidate their holdings. When the Fed announced its repo intervention. It didnt talk about hedge funds or basis trades or the fact that it was improvising a new system for controlling overnight loan rates. As the repo bail out continued over weeks and months, Fed officials like Powell and Logan talked about if as if it were a routine form of system maintanence. The Fed was trapped by its own past actions. It was committed to a level of intervention and money creation that would have once seemed wildly improbable. This is what it took to keep basic market functioning.
Robinhood:
Robinhoods platform was made to look like something that democratized high finance, moving riches of stock trading from Wall Street to the family living room. But Robinhoods business model was dominated by the same big players that already operated at the peak of financial power. The people who traded on Robinhood were not the companys real customers. Its real customers were big hedge funds and trading firms like Citadel Securities. Robinhood might have organized all the trading through its app, but the trades were actually executed through Citidel. These firms paid Robinhood millions of dollars for the privilege because it allowed them to see what people were buying then make trades based on that information as they filled the order. This was called Payment for order flow. Robinhoods cash from order flow more than tripled from the start of 2020 to the same period in 2021. Its unclear how much money Citadel earned from the arrangement, because its privately held. Market swings were hard to predict, but Citadel had a good view into how things worked at the Federal Reserve. In 2015, the company hired Ben Bernanke to be a senior advisor.