Perspective on Risk - Feb. 23, 2024
Supervising The Changing Financial System; Proactively Addressing Bubbles; Proactively Addressing Bubbles; Some Other Risk Observations
Supervising The Changing Financial System
We’ve talked about how the nature of the financial system continues to evolve. In the 1990s, the major change was the rise of hedge funds, that took risks outside of the regulated bank and investment bank sectors. Interest in understanding the financial stability risks accelerated with the failure of LTCM.
Hedge Funds
Bill Dudley, former President of the NY Fed, spoke about one of his better innovations while President in Masters In Business: Transcript: Bill Dudley, NY Fed Chief.
… the one thing that I did that was probably a little new from the Fed’s perspective is I tried to broaden out the, the people that the New York Fed was talking to historically, the New York Fed had typically talked mainly to the primary dealer community. So that’s where they obtained their information from. And I thought that that was too narrow. We need, we need, we need a broader set of perspectives. And so I hired a, a woman named Hailey Bosky who came in and, and literally built out a whole operation so we could actually interact not just with the sell side, but also with the buy side.
And so we started an advisory group of people, you know, hedge funds, pension funds, insurance companies, you know, buy side investors. And so we have them in periodically to talk to. And so we got a much broader network of information that we could sort of take on board. And I think that’s valuable because, you know, where you sit really does influence your perspective and you sort of wanna understand what biases and, you know, self-promotion sometimes that people are talking their book that you want to be able to make sure you, you don’t get to fooled by that.
I worked quite a bit with Haley. During the GFC, her work was extremely valuable. There are times when the Fed needs information to formulate policy, but doesn’t need to be involved directly in (burdensome) regulation. This was one.
PE, Digital Payment Providers, & Commerce
Now, OCC Comptroller Hsu, in a speech covered by Bloomberg in PE’s Private Credit Push Can Pose Stability Risk, Bank Regulator Says, states:
Since PE firms are not subject to consolidated supervision, it is not possible for regulators and other outsiders to assess how risky and interdependent these activities are
Honestly, this is the best speech I have read by Hsu.
His remarks are actually broader and more insightful, discussing the separation of banking and commerce.1
The economic and banking history of the U.S. includes numerous financial crises. Three stand out, though: the Panic of 1907, the Great Crash of 1929, and the 2008 Global Financial Crisis. Each of these was preceded by a multi-decade period when the line between banking and commerce was blurred. The blurring occurred narrowly and slowly at first, then expanded and accelerated rapidly—a great blurring—until each crash.
Over the next decade I believe the risk of blurring is highest in two areas: payments and private credit/equity.
There are significant parallels between Hsu’s remarks, Corrigan’s original 1982 Are Banks Special? and Fed Gov. Olson’s 2002 Are Banks Still Special?
Hsu builds on many of Corrigan's arguments around the special status of banks and appropriate separation from commerce. Corrigan focuses on defining banks around deposit-taking (or more appropriately money creation). Hsu takes a broader view focused on payments (which of course was an obsession of Corrigan’s as well).
Corrigan focuses on the deposit-like aspects of money market funds, while Hsu focuses on the banking/payments convergence, the ability of digital payments providers to be ‘run’, and the rebundling payments, lending, and deposit-taking.
Corrigan implicitly comments on runs by stating that banks access to the discount window is something that makes them special - ultimately all payments settle through banks. This is the one area where Hsu’s speech is perhaps lacking. Discussing the ultimate settlement role of banks could have strengthened Hsu's arguments around payments and added an additional dimension to his points, and is an area for further discussion.
Proactively Addressing Bubbles
As indicated above, Bill Dudley participated in a podcast with Barry Ritholz. He throws Alan Greenspan under the bus for being an “anti regulator” and highlights both the shift in thinking towards a more proactive approach and the difficulty in getting market participants to change their behavior.
Masters In Business: Transcript: Bill Dudley, NY Fed Chief
Dudley: So there’s been a big, big debate going on for many, many years about, you know, how should the Fed respond to financial imbalances in the economy? You know, how should they respond to sort of incipient bubbles? The Greenspan view was, it’s very hard to recognize bubbles. It’s not clear how you reign them in. So the best thing to do is just sort of let the bubbles take the, run their course and then clean up after the bubble collapse. It’s, and you’re in the bus period. My view has been very much that no, that’s, that’s not a great strategy because the bursting of the bubble can cause a lot of financial knock on effects. And so better to identify the bubble in real time and try to sort of reign that bubble in. And I think, you know, if you look at the 2004, 2007, eight period, boy, it would’ve been really good if we’d done something about subprime mortgage lending, about mortgage underwriting standards.
If we’d done that, we would’ve had a much smaller housing bubble and we would’ve had much less damage when that bubble collapsed in, in 2008. So my view has always been, let’s, let’s try to be a little bit more proactive. Now, the problem with, with being proactive is, you know, how do you know it’s a bubble? And the reality is you don’t. And so it’s very hard to convince people to take proactive steps to deal with sort of incipient problems because you can’t really be sure with a hundred percent confidence of what’s actually going on.
Here, the classic example is Citi’s Chuck Prince, who once said:
As long as the music is playing, you've got to get up and dance. We're still dancing.
The Fed wasn’t very happy with him. Dudley then throws Greenspan under the bus
But you’re also pointing out to the Fed as regulator and, you know, to, to cast blame. Greenspan was very much a anti regulator... And, and he allowed a lot of non GSE non-traditional banks to make all sorts of loans. It’s not like he gave them permission, he just didn’t really regulate them. And that’s where a lot of the really sketchy and the Fed and subprime came from. And the Fed actually did have some authority in terms of regulating the mortgage market authority that they didn’t really use. Nick Grahamlick was a governor at the Fed, and he sort of brought his concerns to Alan Greenspan. And, and nothing really, really happened.
The problem here is in identifying the bubble. Prior to the GFC, even when talking with bank risk managers, it wasn’t clear exactly what was going to break. Risk managers at the large investment banks were more worried about stuck syndications, like Alliance/Boots that was clogging their balance sheets. And some economists at the Fed were asserting that the housing market was not in a bubble.
Treasury Basis Trade
So back to hedge funds.
Even with the burgeoning commercial real estate problems in the regional banking sector, the one risk that the Fed and other policymakers seem to obsess about these days continues to be the highly leveraged Treasury basis trade. We’ve written before about policymaker concerns about the Treasury basis trade. In this trade, a hedge fund takes a long position in a US Treasury bond, and shorts a futures position to offset its duration risk. This subjects the hedge fund to collateral call risk and, given the small profit margin, this must be a highly-leveraged trade.
The Hedge Fund Traders Dominating a Massive Bet on Bonds (Bloomberg)
the “basis trade” [is] a bet by a few of the world’s biggest hedge funds that profits from the tiny price gaps between Treasuries and … futures … a core group of 10 or so firms … rely on vast sums of money borrowed from Wall Street banks — often 50 times what they invest themselves — to pump tens of billions of dollars into the trade.
As the availability of this short-term lending has surged this year, the basis trade has boomed. The net short position on Treasury futures, a reasonable proxy for the wager’s popularity, has spiked to $800 billion from $650 billion in July, the Bank of England said on Dec. 6.
According to the article, the players in this trade are firms most have never heard of (they like it that way): ExodusPoint Capital Management, Millennium Management, Citadel, Capula Investment Management, Symmetry Investments, Balyasny Asset Management, Kedalion Capital Management, Tudor Investment Corp.
Why does this trade exist? It’s simple really; this is maturity intermediation for the non-bank market. Some investors need long-term asserts to offset their liabilities (think life insurance, pensions, and active bond managers). While they may need the duration associated with long-term assets, 1) there may not be enough of these assets to satisfy demand, and 2) even if there is enough assets, they may choose to source their credit risk in shorter term assets (think floaters). Similarly. there is an enormous amount of institutional cash that needs to be invested, and the preferred safe investment is US T-bills and the repo market. The basis trade enables long-term investors to efficiently go long Treasury futures to add duration with the hedge funds taking the opposite side of the trade. Nothing wrong with any of this.2
The TBAC presentation, which we’ll discuss shortly, has this nice graph:
Steven Kelly (again) has a nice substack Can the Treasury Kill the Basis Trade? (Without Warning) that discusses the trade through the lens of a recent Treasury Borrowing Advisory Committee presentation Discussion of Treasury Futures Positions Across Different Investor Types. Read his piece. In addition to the factors I cited above, Steve notes:
… the TBAC found is that active fixed income managers are stuck benchmarking to aggregate bond market indexes, which have increasing amounts of Treasuries in them. … The TBAC presentation shows that as bond market benchmark indexes flood with Treasuries, asset managers tend to just pick up this duration exposure with Treasury futures, rather than reallocating their portfolio away from their lower-duration-risk credit investments:
He also cites Treasury preference for funding at the short-end of the curve (which we can also see through the Fed’s Standing Overnight Repurchase Agreement Facility).
Or we can cite the TBAC presentation which states:
Procyclical fiscal stimulus, which has contributed to rising Treasury allocations in bond indices alongside a healthy economy, may be amplifying this trend.
Steve doesn’t really address WHY policymakers are concerned about the trade (or in his words, why they would want to kill it). The traditional answer here is the potential for a highly leveraged hedge fund to ‘blow up’ causing asset fire sales. collateral liquidation and possibly counterparty losses. We’ve discussed before that for a very long time Federal Reserve examiners have focused on prime brokerage and collateral management for this very reason.
Melissa Davies, chief economist at Redburn Atlantic, has penned an FT article, The Fed’s QE comeback could be dangerous (FT), with some further nuance:
The Fed has already started down the path to resuming quantitative easing. The question is whether they do so before, or after, upending the highly-leverage hedge fund basis trade that has been supporting the Treasury market.
The assumption has been that ON RRP drainage was protecting bank reserves and that, only once these reserves started to fall would we have to worry about a rerun of 2018.
But the ON RRP may have been playing an altogether riskier role in bond markets — financing the proliferation of the so-called hedge fund ‘basis trade’, whereby hedge funds borrow to buy Treasuries and sell Treasury futures to make a tiny return, leveraged up multiple times.
The problem is that the basis trade is financed in the private repo markets, and it is money market funds — drawing down their ON RRP cash — that are financing this trade.
Instead of scarce bank reserves creating liquidity problems and forcing the Fed to stop QT, it may well be the exhaustion of the ON RRP and the upending of the hedge fund basis trade that causes problems in 2024. The worrying difference now is that there is no Fed backstop for hedge funds and the high degree of leverage used in the trade could lead to liquidity problems proliferating even more quickly through the financial system.
RRP and Reserves
The journey we have taken today leaves us talking about the RRP facility and bank reserves.
Reverse Repo Program
The NY Fed published a Liberty Street piece in December Dropping Like a Stone: ON RRP Take-up in the Second Half of 2023 that provides some context for the RRP.
The increase in ON RRP take-up between 2021 and May 2023 was driven by a series of factors: a rise in banks’ balance-sheet costs due to the expansion of the supply of reserves in response to the COVID-19 pandemic, the rapid hikes in policy rates aimed at fighting inflation and the resulting increase in interest-rate uncertainty, and the decrease in the T-bill supply of 2021-22 resulting from the normalization of public debt after the COVID-19 crisis.
These factors have reversed: the Federal Reserve restarted running off its balance sheet after the temporary expansion during the banking turmoil of March 2023; the growth of the banking system waned while the ratio of reserves to asset decreased; the pace of interest-rate hikes slowed down; and the T-bill supply increased again. If these dynamics persist in the months ahead, ON RRP take-up may continue to decrease. Such a steady decline would be consistent with that observed in early 2018, when investment at the ON RRP gradually disappeared as the Federal Reserve continued to normalize the size of its balance sheet and reserves in the banking system became less abundant.
Target Level of Reserves
So the Fed is now focused on determining what is the ‘normalized’ level of reserves in the banking system. The two areas to watch are Lorie Logan, President of the Dallas Fed who was once the System Open Market Manager at the NY Fed, and John Williams/NY Fed who watches the markets and executes on monetary policy
Lorie Logan
Opening remarks at panel on Market Monitoring and the Implementation of Monetary Policy
Logan emphasizes the desire to ‘go slow’ - why:
[because] a premature easing of financial conditions could allow demand to pick back up. Restrictive financial conditions have played an important role in bringing demand into line with supply and keeping inflation expectations well-anchored.
a lot of the effects of higher rates are already behind us, and the recent easing in conditions could start to push up on aggregate demand.
She is focused on the markets.
Money markets and policy implementation are continuing to function smoothly.
And no longer believes liquidity is ‘super-abundant.’
The emergence of typical month-end pressures suggests we’re no longer in a regime where liquidity is super abundant and always in excess supply for everyone. In the aggregate, though, as rate conditions demonstrate, the financial system almost certainly still has more than ample bank reserves and more than ample liquidity overall.
The most recent Senior Financial Officer Survey shows that most banks in the sample have reserves well in excess of their lowest comfortable levels and desired buffers.
… while the current level of ON RRP balances provides comfort that liquidity is ample in aggregate, there will be more uncertainty about aggregate liquidity conditions as ON RRP balances approach zero.
How Low Can Reserves Go?
A NY Fed research piece, that importantly includes NY Fed Pres. Williams among the authors, Scarce, Abundant, or Ample? A Time-Varying Model of the Reserve Demand Curve (NY Fed) tries to quantify the reserve demand curve.
We provide a model of the reserve demand curve in the United States and estimate it at daily frequency over 2010-21 using an instrumental-variable approach combined with a time-varying vector autoregressive model. … We have three main empirical findings.
First, as predicted by economic theory, the reserve demand curve is highly nonlinear with a clear satiation level: it is flat when reserves in the banking system are sufficiently abundant; and increasingly negatively sloped as reserves decline below the satiation point, moving from ample to scarce.
Second, the reserve demand curve has shifted horizontally: in the earlier part of the sample, we observe a significantly negative slope when reserves are below 12 percent of banks’ assets; in the second half, when reserves drop below 13 percent. These findings suggest that banks’ demand for reserves has increased over time.
Third, the curve has also shifted vertically, especially in the later period. This observation implies that the level of the federal funds-IORB spread may not be the appropriate summary statistic for the rate sensitivity to reserve shocks.
As of year-end, reserves equaled just under 15% of banking sector assets. A target of 13% would imply another $70 bln of reserve drainage.
So what this all means is that we are near the end of monetary policy normalization. Yes, there may be further tinkering with the size of the Fed’s balance sheet, but there is no pressing need to reduce the balance sheet further.
Some Other Risk Observations
EM Debt
Venezuela’s State Oil Company Bonds Collapse After Court Ruling (Bloomberg)
Bonds from state-owned Petroleos de Venezuela SA collapsed after New York State’s top court ruled Venezuelan law will determine whether the debt is valid.
New York's top court leaves question of PDVSA bonds' validity open (Reuters)
New York state's top court on Tuesday ruled that Venezuelan law governs whether bonds issued by state oil company Petroleos de Venezuela (PDVSA) are valid, but left the decision over whether the bonds should be deemed invalid up to federal courts.
The New York State Court of Appeals took up the question after Venezuela's opposition - which has controlled PDVSA's U.S. assets, including refiner Citgo Petroleum, since 2019 - argued that PDVSA's bonds maturing in 2020 had not been approved by Venezuela's National Assembly and thus were invalid.
Chatbot Risk
Air Canada Has to Honor a Refund Policy Its Chatbot Made Up (Wired)
Air Canada was forced to give a partial refund to a grieving passenger who was misled by an airline chatbot inaccurately explaining the airline's bereavement travel policy.
Operational Risk
Including linking back to my favorite foundational piece, Corrigan’s Are Banks Special?
In fact, the TBAC presentation specifically concludes “We suggest that a mutually beneficial relationship exists between asset managers and leveraged fund positioning in Treasury futures.”