Last month, we got a glimpse of what such a drama could look like. After Liz Truss, the hapless former Prime Minister of the United Kingdom, announced a tax cut that would have required significant new government borrowing, investors dumped government bonds, known as gilts . This had the effect of driving up interest rates and lowering the value of the pound sterling. These higher rates, in turn, threatened the solvency of Britain’s private pension funds, which had all piled into a complicated derivatives trade that now required them to provide trillions of pounds in additional collateral. Desperate for cash, pension funds sold their government securities, turning what had been a bond market rout into a meltdown. To deal with the crisis, the Bank of England, which had been busy selling gilts to calm inflation, was forced to backtrack and announce that it would buy as many gilts as necessary to stem the panic.
The unrest in London sent stock and bond prices plummeting around the world, undermined the credibility of the Bank of England and forced Truss’s resignation. But on Wall Street and Washington, where markets have been extraordinarily volatile and the appetite for buying bonds and other credit is in decline, it was taken as a warning that something similar could happen here.
‘What happened in the UK – part of it is a self-inflicted wound, but part of it is tremors of what is happening in the global system,’ the former Treasury secretary said Larry Summers to global financiers and finance ministers in Washington last month at the annual meetings of the World Bank and International Monetary Fund. “When you have tremors, you don’t always have earthquakes. But you should probably think about earthquake protection.
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In a decade of artificially low interest rates, governments and corporations have taken on mountains of debt, there has been an orgy of overvalued and anti-competitive corporate mergers, and the financial system is plagued by speculative excesses.
Much of this speculation has taken place in what is generally referred to as shadow banking – opaque, unregulated markets that now provide the majority of credit to American businesses and households.. The Trump administration has been blithely dismissive of the systemic risks accumulating under its watch. Biden’s team was significantly more aggressive in demanding better “stress tests” and running “stress tests” to ensure that shadow system disruptions would not lead to a collapse of regulated banks.
But what regulators haven’t done is step in and force the wise men of finance – hedge funds, high-frequency traders, private credit funds, and their friends at the brokerage offices major investment banks – to unwind their riskiest positions. or shore them up with more of their own money.
In Britain, for example, as early as 2018, regulators flagged potential systemic risks posed by interest rate hedging schemes adopted by pension funds. Yet, lacking backbone or imagination, they did nothing about it.
The reality is that the shadow banking system is now so vast and opaque, the transactions and instruments so complex and intertwined, and the players so gregarious in their behavior that any dramatic movement in the price of a security, commodity, of a currency – or a player’s collapse – can set off a chain reaction that could ultimately crash the whole system.
This is what happened in 1997 during the Asian financial crisis. It happened a year later when the Fed was forced to bail out a highly leveraged hedge fund named Long Term Capital Management. This happened again in 2007 with the collapse of the mortgage investment funds managed by Bear Stearns. And after the recent unrest in Britain, there are growing fears that it could happen again here.
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Like today, all of these previous crises occurred as the Fed and other central banks moved to raise rates after a long period of easy money and rampant speculation that inflated the value of financial assets.
When a credit bubble bursts, the descent can be quick and bumpy.
We see this in the rat race in the stock market over the past six months, the sharp decline in bond prices, the fading of the cryptocurrency market and the cooling of house prices. Many, like Summers and JP Morgan’s Jamie Dimon, predict that bottom is not yet in sight.
We see it in the dramatic drop in investor demand for “leveraged loans” used to fund corporate buyouts and stock buybacks, forcing some of Wall Street’s biggest banks to suffer hundreds of millions of dollars in losses on loans they made but could not resell.
In March 2021, Archegos Capital Management shook stock markets and caused tremors at some of Wall Street’s biggest banks when it was unable to find the cash to cover losses on its highly speculative portfolio of derivative contracts known as “total return swaps”. In the end, hedge fund officials were charged with securities fraud and Credit Suisse was forced to take a loss of $5.5 billion, Nomura Holdings of $2.8 billion, Morgan Stanley of almost a billion dollars and the UBS group of 774 million dollars.
The Fed and the Treasury are particularly concerned about the decline in interest in the Treasury bill market. Foreign central banks and insurance companies whose returns are reduced by the rising value of the dollar are gone. Commercial banks seem to have decided that they would rather continue to lend money to businesses and consumers than to the Treasury. And as always happens when rates rise, pension funds and fund managers are hesitant to buy treasury bills earning 4% interest when they are fairly certain they will soon be able to buy bonds yielding 5% interest.
Treasuries shakes worry Wall Street and Washington
In response, the Fed attempted to increase the amount of readily available cash circulating in the financial system by encouraging banks to borrow against the bonds they already own without having to sell them. There is also speculation that the Fed could relax regulations requiring banks to set aside some of their own capital to cover the risk of loss in the value of Treasuries. At the Treasury, meanwhile, officials are considering the unusual move of borrowing new money to buy back old bonds for which demand is particularly weak.
All this worry about a financial crisis is putting pressure on the Fed to ease its plan to continue raising rates in the first half of next year and – perhaps even more importantly – cancel plans to sell $1 trillion in treasury bills and mortgage bonds he accumulated to stave off financial crises in 2008 and again in 2020. This strategy, known as “quantitative easing,” ended up flooding the $8 trillion financial system created out of thin air.
So far, Fed officials have signaled their determination to continue selling bonds and removing that cash from the economy, at least until there are clear signs of a slowdown in the economy. ‘inflation.
“They’re going to push until something breaks,” said Scott Minerd, chief investment strategist at Guggenheim Partners.
If and when that breaking point is reached, have no doubt that the Fed – like the Bank of England – will step in as a lender of last resort and promise to do “whatever it takes” to restore order to the trading in financial markets. And with that, the Fed will have been forced to call a ceasefire in its war on inflation and put a floor under the price of financial assets.
What President Jerome H. Powell and his colleagues are now discovering is that it is much easier to inject trillions of dollars into the economy to avert a calamity than it is to claw that money back once the crisis is over. Once banks, businesses and investors have come to rely on this money and build their financial arrangements around it, any effort to withdraw it can cause a “money rush” as people are rushing to sell their holdings before prices fall even further.
And like any old-fashioned bank, if everyone shows up at shadow banking to ask for their money, they’ll find the money isn’t there – not because it’s been lost, but because was lent to someone else. The essence of every financial crisis is a kind of bank run.
The challenge the Fed now faces is how to withdraw its money from the financial system without scaring everyone into withdrawing theirs.
Steven Pearlstein is a former business and economics columnist for The Post. He is now the Robinson Professor of Public Affairs at George Mason University.