Weekly Commentary: Hooked On Hedge Fund Leverage

2025-04-26 04:22:20 ET

Summary

• With a huge S&L bailout contributing to ballooning federal deficits, a major banking system recapitalization risked pushing Washington's finances over the edge.
• Beginning the month at 5.64%, 10-year Treasuries ended February at 6.13% - on the way to a May peak of 7.48% and November high of 8.03%.
• Major dislocations in the fledging derivatives marketplace took down Askin Capital Management.
• U.S. bond funds came under heavy selling pressure in the week to April 16, highlighting concerns that U.S. President Donald Trump's tariff measures could fuel inflation and push the economy into a recession.

After three decades, I remain as skeptical as ever. Unconstrained Credit is destabilizing. Market-based (as opposed to traditional bank) finance took hold during the nineties and never looked back. Between July 1990 and September 1992, the Greenspan Fed slashed rates 525 bps to an at the time unprecedented 3.0%. It was desperate times. The eighties Bubble had burst, leaving the economy in recession and the banking system deeply impaired. With a huge S&L bailout contributing to ballooning federal deficits, a major banking system recapitalization risked pushing Washington's finances over the edge.

What on earth does this have to do with the current environment? Alan Greenspan orchestrated a surreptitious banking system recapitalization that unleashed a financial revolution, a fundamental transformation of market and financial structure that I believe is now in the process of what could prove a momentous test.

Greenspan created an artificially steep yield curve, allowing banks to borrow inexpensively while leveraging higher-yielding government bonds (and other Credit instruments). Importantly, this free "money" bonanza was manna from heaven for the fledgling hedge fund community. Meanwhile, collapsing deposit rates spurred disintermediation from the banking system, with an enterprising Wall Street fixated on "harvesting assets." Rapid money market growth accelerated, with money market fund assets surging 19% in 1992 (to $570bn). "Money" flooded into equities.

Awash in "cheap money", "Wall Street finance" hit overdrive. Broker/Dealer Assets (from Fed's Z.1) surged 19% in 1991, 20% in 1992, and 24% in 1993. System "repo" liabilities jumped 18% in 1992 and 14% in 1993, surpassing $1 TN for the first time in 1993. Assets-backed securities surged a record $82.5 billion, or 22%, in 1993, capping off unprecedented four-year growth of $256 billion, or 122%. GSE securities also ballooned, posting record four-year growth of $640 billion, or 51%.

The latent instabilities of this new financial structure were laid bare on February 4th, 1994, when the Fed raised rates a "baby step" 25 bps to 3.25%. Beginning the month at 5.64%, 10-year Treasuries ended February at 6.13% - on the way to a May peak of 7.48% and November high of 8.03%. The first major hedge fund deleveraging was painfully destabilizing. Hedge fund losses were enormous, including major drawdowns for funds managed by "masters of the universe" Michael Steinhart and Julian Robertson. Major dislocations in the fledging derivatives marketplace took down Askin Capital Management. The effects of U.S. bond market deleveraging were felt globally, most painfully with the December 1994 Mexican peso and bond (tesobonos) collapse.

April 24 - Financial Times (Robin Wigglesworth, Kate Duguid, Costas Mourselas and Ian Smith): "Over the past few weeks, the bond market has done what many of Donald Trump's opponents have failed to do. It has forced the American president into a partial retreat on tariffs, after a rout in US government debt threatened to spill over into a financial calamity... Many stress that the turmoil was also exacerbated by highly leveraged hedge fund strategies. These 'relative-value' trades usually seek to take advantage of often tiny differences in prices between Treasury bonds and various derivatives contracts linked to them. Using short-term funding markets to borrow extreme amounts of money, they can transform small profits into large ones. These trades have helped turn the club of big hedge funds that pursue them into vital pillars of the $29tn Treasury market… However, many fear that they also make Treasuries vulnerable to sudden shocks. Even the Federal Reserve has argued that the growth of these leveraged hedge fund strategies - such as so-called 'basis trades' or 'swap spread trades' - is a risky development for a market that funds the US government, historically acts as a safe shelter for global finance and influences the pricing of virtually every other security on the planet… The gross US government bond holdings of all hedge funds that report to the SEC stood at nearly $3.4tn at the end of 2024, and has roughly doubled just since the beginning of 2023… Much of this will be held through myriad other strategies, but judging by the size of the short Treasury futures positions, most estimates are that fixed-income relative-value hedge funds in aggregate probably hold roughly $1tn of Treasuries."

Looking back, 1994 was the first of a series of crises where the wrong lessons were learned and later reinforced. Hedge fund speculative leveraged had become a serious issue. The money market, "repos" in particular, was the epicenter of destabilizing leveraging. More generally, "Wall Street finance" was inherently unstable, promoting Credit excess and boom and bust dynamics. Celebrated as instruments to manage and control myriad risks, the proliferation of derivatives strategies created innate systemic vulnerability....

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