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The Next Meltdown

One Scary Scenario for What Could Go Wrong

By John Lekas, Leader Capital

A friend of mine was bragging the other day about the returns in the “529” college investment fund he set up years ago for his daughter: up an impressive 27% last year, up an average of almost 13% per year for the past ten years.

So, is my pal smart—or just lucky?

When the Dow stock average plunged a thousand points on coronavirus fears on Monday (Feb. 24th) and followed that with a drop of another 800+ points a day later, a lot of us were feeling a lot less smart.

We have been lucky for a decade, benefitting from the enormous and sustained rally in stocks since the Great Meltdown of 2008. And despite the new virus outbreak, there is plenty of reason for optimism in 2020 and beyond. Inflation remains tame, and the Fed seems willing to hold back from raising rates—and the virus impact gives it even more reason to do so. The China trade deal could ease tensions with our biggest rival.

More importantly, the impeachment (and acquittal) of President Trump is a sad joke that may backfire on the Democrats and help him win re-election. This would be better for stocks and the economy. (Hold your fire: that doesn’t mean I support @realDonaldTrump, it just means his policies are more pro-business, pro-tax-cuts, and pro-wealth-creation.)

The question is what could go wrong with this picture. At Leader Capital, a bond mutual fund firm with half a billion dollars under management, we help investors secure and protect their wealth. The best way to get rich is to “hold on, hold on, hold on… to what you’ve got,” as an old 1970s song advised. (I always liked the Ian Gomm version.)

Where might the next crash begin? The temptation is to search for it in the Big Picture—a pandemic virus that kills a million people, or a sudden explosion in the trade war, or a nuclear confrontation with North Korea.

In truth, the next crash could begin in the arcane backwaters of a single entity.

The Great Meltdown of ’08 owed in part to one seemingly invincible Wall Street titan, Lehman Brothers, and its unwise dealings in the “repo market,” a little-known and even less well understood part of the bond industry.

I bring this up because this same repo market, in one scary scenario, could become Ground Zero for the next market crack. This “repo” is unrelated to “Repo Man,” the cult film classic from 1984. This “repo” is for the $2.2 trillion business in “repurchase agreements,” which trade in an overnight-lending market. A good, quick explainer on Investopedia says, in part:

In the repo market, a firm can gain access to excess funds of other firms for short periods, usually overnight, in exchange for collateral. The firm that borrows the funds promises to pay back the short-term loan with a small amount of interest; the collateral typically never changes hands.

In 2008, Lehman had leveraged its capital 31-to-1, that is, for every dollar it invested it had borrowed 31 dollars more for the same investment, in this case, bonds backed by subprime mortgages. Lehman was reliant on the repo markets for cash and accounting tricks. It was, in essence, committing the sin that always takes down a financial house: borrowing money on the short end (at low short-term rates) to place bets on the long end (in this case, the long-term returns on mortgage-backed bonds).

When the subprime bubble burst, prices of mortgage-backed bonds plunged. Lehman’s lenders demanded more collateral. The repo markets froze, Lehman stock plunged 48% in a single day, and neither government nor its rivals would come to its rescue.

Lehman filed for one of the largest bankruptcies in history, with $600 billion in assets, setting off a global financial panic. The federal government stepped in soon after to bail out the Too Big to Fail banks.

Now hedge funds are doing, in essence, what Lehman was doing: leveraging their assets (20-to-1) to borrow against the short end of the market in repos (overnight loans and loans of 30, 60, or 90 days) to place bets on the long end of the market (in betting on the spreads in 10-year, 30-year and now new 20-year Treasurys).

So a hedge fund can parlay a $100 million bet into $2 billion of Treasurys, and at 20-to-1 leverage, a mere 5% downturn in the bonds’ value can wipe out the hedge fund’s equity overnight. If you have a sudden market hiccup, it’s “Katie bar the door,” a saying I never have quite understood but have always liked.

The repo market already shows signs of strain and a lack of liquidity—too many borrowers seeking overnight cash, and too few lenders with ample free cash they are willing to lend. In September, the overnight repo rate suddenly jumped up to 10%, roughly four times the Fed’s overnight lending rate, startling traders and prompting the Fed to intervene, the Wall Street Journal reported.

Since then the Fed has pumped new liquidity into the repo market by buying more than $400 billion in Treasuries (on top of its $3 trillion+ balance sheet). This intervention already is drawing fire as being heavy-handed instead of letting the invisible hand operate, free and unfettered.

Thus, my scary scenario for what could go wrong: Imagine the Fed and everyone else is surprised by a sudden, huge burst in inflation expectations and a spate of breakaway price increases. The Fed would feel pressure to raise short-term rates early, sharply, and multiple times in succession to “get out in front of this.”

This would scare the fixed-income markets and the stock market, and spread fears of a sudden, deep recession. The 20-to-1 bets in repos suddenly might turn south, freezing up the $2.2 trillion repo market and choking off the flow of daily cash to hundreds of huge companies. Once again, a cascade of falling dominoes might result.

I am hopeful we can avoid this. So far, the Fed has shown it is willing step in and keep the repo cash flowing. In a crisis, imagine how great it would be if the Fed chairman, Jerome Powell, had a close, trusting relationship with the President. Time for Mr. Trump to make nice with the Fed chairman.

We explore that next, in the third and final part of this series. See also Part 1: THE TOPSY-TURVY TWENTIES


This commentary is intended to be general in nature, reflects our opinions and is based on our best judgment at the time of writing. No warranties are given or implied regarding future market activity. This commentary is not intended to be, nor should it be used as a substitute for individualized investment advice. No specific decisions should be made based on this commentary. These opinions should not be construed as a solicitation for any service. Past performance does not guarantee future results.

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