WASHINGTON — As the coronavirus began shuttering the global economy in March, critical parts of U.S. financial markets edged toward collapse. The shock was huge and unexpected, but the vulnerabilities were well known, the legacy of risk-taking outside regulatory reach.
To head off 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 vast array of holdings and rushed to the comparative safety of cash, the Fed pledged to become a buyer of last resort to restore calm to critical markets.
That backstop bailed out many people and investment firms, including a class of hedge funds that had been caught on the wrong side of a trade with ample risks. The story of that trade — how it went wrong and how it was salvaged — offers a cautionary tale about important issues Congress did not address in the 2010 Dodd-Frank financial law and the Trump administration’s hands-off approach to regulation.
A decade after Dodd-Frank, America’s sweeping post-2008 crisis fix, was signed into law, commercial banks like JPMorgan Chase and Bank of America are better regulated and safer, but they may be less willing to help smooth over markets in times of stress. Tougher regulation in the formal banking sector has pushed risk-taking to the shadowy corners of Wall Street — areas that Dodd-Frank left largely untouched.
In addition, the powers that policymakers have to deal with persistent vulnerabilities have been undermined by Trump administration officials who entered office seeking to weaken financial rules. Treasury Secretary Steven Mnuchin, who leads a panel created by Dodd-Frank to identify financial risks, has moved to release big financial firms from oversight and abandoned an Obama-era working group that was examining hedge fund risks.
The result is a still-brittle system, one in which financial players rake in profits in good times but the government is forced to save them or leave the economy to suffer when things go awry.
“It’s very dangerous to have a regime in which you know this can happen,” Janet L. Yellen, the former Federal Reserve chair, said in an interview. “The Fed did unbelievable things this time.”
Relying on the central bank to save the day is not a long-term solution, she 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 so aggressive in the future.
Hedge funds are one risk left unaddressed. Some regulators had warned for years that a certain type of hedge fund — so-called relative value funds — could struggle in a stressed market. Officials also warned that they could not tell how big a risk such funds posed because they did not have enough information about their trades and how much money they were borrowing.
Of particular concern: The hedge funds were using trading strategies similar to those employed by Long-Term Capital Management, a fund that collapsed in 1998 and nearly caused a financial meltdown.
The bet that hedge funds were making earlier this year was simple enough. Called a basis trade, it involved exploiting a price difference in the Treasury market, generally by selling Treasury futures contracts — promises to deliver a bond or note at a set price on a set date — and buying the comparatively cheap underlying securities.
The hedge funds made a tiny return as the price of a security and its futures contract converged. To turn those mini payoffs into real money, they tapped a form of short-term borrowing, called repo, and used it to amass huge holdings of Treasuries. Such trades are often incredibly leveraged.
The problems started as markets became very volatile in mid-March. The repo funding essential to the trades was suddenly hard to come by as financial institutions that provide the loans backed away. Historical pricing patterns broke down, and many trades were no longer profitable. Some hedge funds were forced to dump government debt.
Banks could have acted as stress relievers by buying securities and finding buyers. But they were already holding many government bonds, and could not handle more in part because of regulations established after 2008. Everyone was selling — ordinary investors, foreign central banks and hedge funds. Hardly anyone was buying.
The market for U.S. government debt, the very core of the global financial system, was grinding to a standstill.
“The severe dislocation in one of the world’s most liquid and important markets was startling,” the Bank for International Settlements, a bank to central banks, wrote in its annual report last month.
The Fed stepped in to avert catastrophe, pledging during an emergency Sunday afternoon meeting to buy huge sums of government-backed bonds.
It remains unclear how big of a role hedge funds played in March’s meltdown — even how many and which funds were involved remains hazy. The funds are not required to disclose detailed data about the size of their bets and what and when exactly they sold. By the Bank for International Settlements’s telling, the relative value unwinding was a “key driver” of the turmoil.
Researchers writing for the Treasury Department’s Office of Financial Research said in a report that basis trades definitely went bad in March and that some hedge funds sold their securities, but it is not clear how much the sales impaired Treasury market liquidity. Still, the report acknowledged that the Fed’s intervention may have prevented more dire consequences.
Michael Pedroni, an executive vice president at the Managed Fund Association, which represents hedge funds, said in a statement that “a growing body of evidence” showed that “hedge funds were able to continue providing some liquidity even as banks pulled back on 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 turmoil this spring, the Financial Stability Oversight Council, established by Dodd-Frank, had repeatedly identified hedge fund leverage as a risk. Under the Obama administration, it formed a hedge fund working group to consider the potential risks of many hedge funds employing similar trading strategies.
On Nov. 16, 2016, the working group warned that hedge funds could be a source of instability during turbulent times.
“Forced sales by hedge funds could cause a sharp change in asset prices, leading to further selling, substantial losses or funding problems for other firms with similar holdings,” Jonah Crane, the council’s deputy assistant secretary at the time, told the group. “This could significantly disrupt trading or funding in key markets.”
The working group recommended that regulators gather more information about hedge funds, including their trades — the type of granular data missing from the filing that fund managers made to the Securities and Exchange Commission, known as Form PF.
“Our recommendation was to fix Form PF so we could get the underlying data,” Mr. Crane, now a partner at the consulting firm Klaros Group, said in an interview. “These strategies we thought we saw seemed an awful lot like the Long-Term Capital Management strategies and suggested to us that one should at least be aware of who had exposure to those.”
The S.E.C. chairwoman at the time, Mary Jo White, agreed with the recommendation. But with a new administration coming in, there was little chance to address the issue in the last weeks of the Obama administration.
Richard Cordray, who sat on the council as head of the Consumer Financial Protection Bureau from 2012 to November 2017, said that once Mr. Mnuchin took over, discussion turned to relaxing oversight.
“It was clear from the beginning that he wanted to move the FSOC in a different direction, which was a deregulatory direction,” Mr. 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. Money market mutual funds, bailed out in 2008, required another rescue. Corporate bonds faced a wave of predictable ratings downgrades. That market ground to a standstill, prompting the Fed to undertake its first-ever effort to buy big-company debt.
Risks at lightly regulated financial firms “were not only predictable but well documented,” Lael Brainard, a Fed governor, said during a University of Michigan and Brookings Institution conference in late June. “We’ve now seen not once but twice in only 11 years” risks that were considered highly unlikely threatening the economy.
Ms. Yellen and other policymakers said Congress might need to make regulators responsible not just for individual institutions but for the overall safety of the financial system. Only the Fed has a financial stability mandate, and it applies just to banks.
“There was a flaw in Dodd-Frank,” Ms. Yellen said. “Dodd-Frank gave FSOC the responsibility for dealing with financial stability threats,” but did not convey it with the power to do much beyond cajole other regulators. “If FSOC is to be meaningful, it needs to have power of its own.”