If anyone in the Congressional committees that oversee the Fed had an operating brain cell, they should flay the Fed for its indefensible posture of ignorance and powerlessness. I have to confess to being too annoyed to read the underlying document, its semi-annual report on financial stability and am so instead relying on what I take to be a fair-minded recap in the Financial Times, Fed warns of hidden leverage lurking in financial system.
What I find most disturbing is the rank dishonesty of the Fed, in what looks to be deliberate mischaracterization of the Archegos implosion, made worse by the central bank’s “And how can you expect us to know what’s going on?” anticipatory blame avoidance. To put this another way, the Fed is trying to pre-sell a “whocoulddanode?” defense when that sort of guilty faced, foot-shuffling act is unacceptable after the Fed was caught out being way behind the curve in the runup to the global financial crisis.
Archegos was not a systematic event. Not even close. One hedge fund with so few investors that it ran on a “friends and family” basis (tarted up as “family office”) blew up. It did not bring down any other players. It did briefly roil markets in the stocks Archegos held. Banks collectively lost about $10 billion. By comparison, Paribas paid $8.9 billion in economic sanctions fines to the Department of Justice in 2014, which in current dollar terms is $10.0 billion. No one suggested the Paribas fine was systemic or even a health-threatening blow.
The troubling issue was how did this one hedge fund get to be so leveraged? Here is where the Fed misdirects Congress and the general public:
The US Federal Reserve has warned that existing measures of hedge fund leverage “may not be capturing important risks”, pointing to the collapse of Archegos Capital as an example of hidden vulnerabilities in the global financial system….
Hwang’s high-wire act was hard to monitor because family offices face limited disclosure requirements and because he used derivatives known as equity total return swaps. These instruments enabled Archegos to profit from rises in individual stocks with payments equal to only a fraction of the size of the underlying positions.
First, the hand-wringing about Archegos being a hedge fund able to do sneaky things in dark alleys is all wet. Do you seriously think regulators have all that much visibility into the much bigger (but also known to be tightly run) Citadel? How about the personal portfolios of very large investors? And what about multinational corporations that run their Treasury operations as profit centers, or Apple, which runs an internal hedge fund out of Nevada?
In other words, if the Fed thinks the problem is particular player, “hedge funds” is far too narrow a frame. “Leveraged financial speculators” is closer to the mark.
And they are secretive about their holdings. Any large trader will spread his business among multiple execution firms because the firms can and will trade against him if they know his positions.
Second, the problem is not the opaqueness of the hedge fund’s activity, even though if you read the Financial Times’ account, you would think that that is the the Fed’s big worry. It’s the ability to achieve high levels of leverage. And that’s the fault of the regulatory regime.
In passing, in the section excerpted above, the report mentions total return swaps. A short definition from Wikipedia:
Hedge funds use Total Return Swaps to obtain leverage on the Reference Assets: they can receive the return of the asset, typically from a bank (which has a funding cost advantage), without having to put out the cash to buy the Asset. They usually post a smaller amount of collateral upfront, thus obtaining leverage.
Due to the hour and the state of Google, I can’t find data on the size of the total return swap market, but at the time Archegos blow, it was under $300 billion, which means too small to wreck the financial system (well, unless perhaps they blew up Deutsche Bank).
Perhaps more important, regulators had decided they didn’t like them but from what I can infer, have also been slow to shut down the market. That’s a mistake since it’s clear the purpose of total returns swaps is pure speculation, and any additional price discovery benefit is too marginal to allow the use of so much leverage.
More generally, the Fed and financial regulators seem unwilling to do two essential things. The first is to say “no” to certain activities. Andrew Haldane, in a paper I have mentioned repeatedly, explained that the only answer to the level of societal harm posed by financial crises is prohibition, as in not allowing certain activities. From his seminal speech, The $100 Billion Question, cited in a 2010 post:
More support comes from Andrew Haldane of the Bank of England, who in a March 2010 paper compared the banking industry to the auto industry, in that they both produced pollutants: for cars, exhaust fumes; for bank, systemic risk. While economists were claiming that the losses to the US government on various rescues would be $100 billion (ahem, must have left out Freddie and Fannie in that tally), it ignores the broader costs (unemployment, business failures, reduced government services, particularly at the state and municipal level). His calculation of the world wide costs:
….these losses are multiples of the static costs, lying anywhere between one and five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.
It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.
Yves here. So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. Even though we have described its activities as looting (as in paying themselves so much that they bankrupt the business), the wider consequences are vastly worse than in textbook looting.
Back to the current post. The original sin of the Fed, at least with respect to crises in the modern era, is the decision by Alan Greenspan to do nothing about derivatives. I recall in the mid 1900s gasping out loud when I read that he intended to take a “let a thousand flowers bloom” approach. By then, I had had one of the top derivatives firms as a client and had an appreciation as to how dangerous they could be.
There is a role for derivatives in highly liquid markets for hedging. Banks generally have the underlying volumes of cash transactions to manage FX futures and options on an OTC basis. But all things being equal, it’s preferable to have a central exchange (more stable market structure) or else highly distributed position-taking. Anything in the middle is more prone to meltdowns.
But an even bigger issue is aside from well-established categories of pretty simple derivatives, there’s no justification for allowing financial intermediaries to offer much in the way of OTC derivatives. The overwhelming uses of high margin OTC derivatives are for accounting gimmickry, tax avoidance, or achieving high levels of leverage on the cheap (which means having the bank or lender as bagholder). None of these are positive from a societal standpoint.
So all of the Fed’s mealy-mouthing about hidden leverage is utter rubbish. Yes, asset valuations are strained due to super cheap money and too much speculative froth. But as we saw in the collapse of the monster dot-com bubble, the mere collapse of speculative bubbles, even really big ones, does not do systemic damage (although they can set off recessions as the speculators lick their wounds and the folks with bezzle-based revenues take hits). What does systemic damage is high levels of leverage, particularly leverage on leverage, which was what turned the housing crash from an S&L crisis x 1.5X level event to a global financial crisis.
For the Fed at this juncture to profess to be so stupid about the fundamental problem as cover for their unwillingness to take on Big Finance is depressing, although in another way, not exactly surprising.