Commentary on Political Economy

Monday 27 July 2020

We have argued to despair on this Blog that the global financial system is heading toward Armageddon.  The terrifying truth is that monetary authorities have been unable and unwilling to take measures to reform the capitalist system in ways that could safeguard its near future by quelling the waves of speculation that have engulfed this system since the fall of Bretton Woods. The inability of these authorities to restrain irrational exuberance has led global capitalism to financial crises of increasing scale and complexity, to Minsky and Lehman moments that now pose a clear and present danger to our parliamentary democratic regimes. In the face of seemingly unstoppable speculation in the financial markets and the incendiary spread of the Chinese Virus,  the best advice I can give our friends is to brace and prepare for the worst,  that is,  a New Great Depression and the rise of authoritarian proto-fascist movements. 

Too big to fail: How the Fed averted another financial crisis

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It is clear with hindsight that the US Federal Reserve Board’s decision in March to throw the kitchen sink at whatever the coronavirus would do to financial markets provided a turning point for the US financial system, and prevented it from breaking.
That begs the question of what might have happened had the Fed not acted so quickly and emphatically to pour liquidity into the US and global financial systems. A number of post-mortems on what was happening at the epicentre of market action have suggested the Fed averted another financial crisis.
A research paper published by the Fed itself this month said that that a sudden $US100 billion ($140 billion) tightening of liquidity in the market for Treasury securities created a moment equivalent to the collapse of the big US hedge fund Long-Term Capital Management in 1998.

John Williams, president of the Federal Reserve Bank of New York, said markets nearly buckled.
John Williams, president of the Federal Reserve Bank of New York, said markets nearly buckled.CREDIT:BLOOMBERG

The paper said the decline in liquidity was significantly smaller than what had occurred when Lehman Brothers collapsed in 2008 and precipitated the global financial crisis, although who knows what might have happened had the Fed not intervened.

In a speech earlier this month, New York Fed President John Williams said the markets for Treasury securities and mortgage-backed securities, which were normally highly liquid, nearly "buckled" under the strain of the massive flows of funds in response to the pandemic.
The market for Treasury securities provides the foundation of the US financial system and is a key plank – in fact, the key plank - within the global system.
[The Fed's action's] did buttress the market’s conviction that in any moment of stress and in response to any market tantrum the Fed will step in, as it has since the financial crisis, to protect investors from loss and inflate, or re-inflate, the value of financial assets.
The functioning of that market influences the markets for corporate debt. Historically, if there is illiquidity in the market for Treasuries, access to corporate debt and mortgage financing dries up, among other forms of credit. There’s also a correlation between liquidity in the Treasury market and the sharemarket.
What happened in that market in March has echoes of an event last year and provides more insights into the way the post-financial crisis banking reforms have changed the way key markets function and have, in some respects, introduced new vulnerabilities.
In particular, they highlight the importance of "shadow banks", or non-bank financial institutions, to the functioning of the system. These entities – hedge funds and the like – are lightly regulated.
While the post-crisis reforms did force some of their operations to become more transparent, the Trump administration’s deregulatory efforts – namely its rollback of some of the post-crisis Dodd-Frank reforms to financial regulation in the US – halted efforts to increase the supervision of non-banks and made it near impossible for a non-bank or a cohort of non-banks to be deemed systemically important.

Fixing the plumbing

Indeed, the US Treasury went so far as to advocate the banning of the term "shadow banking" by regulators and government agencies, replacing it with "market-based finance", such was the administration’s aversion to a description that Treasury Secretary Steven Mnuchin (a former hedge fund manager) regards as pejorative.
What happened in March before the Fed intervened was similar to what happened last September, when the plumbing of the US financial system seized up.

US Treasury Secretary Steve Mnuchin regards the term "shadow banking" as pejorative.
US Treasury Secretary Steve Mnuchin regards the term "shadow banking" as pejorative.CREDIT:AP

"Repo" markets provide short-term liquidity to companies and institutions in exchange for high-quality collateral like Treasury bills. Borrowers sell the securities for cash while contracting to buy them back in the near term for a marginally higher price. A sudden liquidity squeeze in that market saw "repo rates" soar and the market freeze before the Fed pumped billions of cash into the market.
In early March, the market was functioning normally before the sudden awareness of the economic impacts of the pandemic caused yields to slump, volatility to spike and bid-ask spreads – the margin between what price sellers of securities want and what buyers are prepared to pay – blew out. Investors and traders were cashing up.

Flight to cash

Major players in the repo market are hedge funds pursuing a simple arbitrage trade, buying Treasuries and selling interest rate futures to profit from the tiny margins available in what is usually termed the “basis” trade.
To make the profits worthwhile, those hedge funds use a lot of debt and also use the Treasuries they acquire as part of the trade as collateral for cash, which they then use to buy Treasuries in a continuous loop of transactions.
That’s a strategy that works until it doesn’t – until there is a flight to cash, as there was in early March, which caused the hedge funds engaged in the basis trades to lose heavily as they tried to cover their positions under the pressure of margin calls. Instead of buying Treasuries they were selling them and instead of selling futures they were buying them to close out their trades.
When the Fed intervened with its open-ended purchases of Treasury securities and mortgages, providing a massive injection of liquidity, it not only restored the functioning of the markets but it also effectively bailed out the hedge funds, both domestic and international.
Shadow banks, it appears, are too important and too big – they play too critical a role in the functioning of the markets for liquidity and credit – to be allowed to fail.
The Fed would no doubt see this – and a parallel impact on sharemarkets that enabled equity investors to recover the heavy losses they had experienced in the previous month or so -- as an unintended consequence, albeit not necessarily an adverse one if the alternative is a broken or at least malfunctioning financial system.
Its actions were designed to maintain a flow of credit to businesses and households and ensure the regulated element of the financial system continued to operate smoothly. They worked.


They did, however, also buttress the market’s conviction that in any moment of stress and in response to any market tantrum the Fed will step in, as it has since the financial crisis, to protect investors from loss and inflate, or re-inflate, the value of financial assets.
The concept of risk-free markets and a state-provided safety net for investments by leveraged and non-regulated institutions is contrary to the fundamental principles of market capitalism.
That might help explain why, in the post-financial crisis era, capitalism has been under increasing attack from those on the wrong side of policies that bail out wealthy institutions and individuals and lead to increased income and wealth inequality.

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