For years, regulators have tried to make the financial system safer by blocking banks from taking on the extreme leverage that almost toppled the industry in 2008. Turns out, the risks just moved.
In a matter of days, a slew of trades unraveled to expose various forms of soured levered bets at their heart. Michael Hintze’s flagship hedge fund scrambled to contain losses on a structured credit trade gone awry. Banks including Citigroup Inc. tried to sell $1.3 billion of risky loans to unwind clients’ leveraged wagers. Funds that borrow to load up on mortgage bonds fed a flood of liquidations. A similar situation played out at municipal-bond funds.
In 2008, the culprits were real estate speculators, investments banks that fueled the bubble while leveraging books about 40 to 1, and investors who failed to conduct their own due diligence. A wave of defaults caused that system to come crashing down.
This time, another long period of rock-bottom interest rates, most recently cheered on by President Donald Trump, has let companies go into record debt while showering cash on shareholders. The enablers are banks eager to facilitate deals and investors desperate for higher returns. They borrowed to multiply profits on mortgages, junk debt and municipal and government bonds. The leverage means losses are getting amplified too.
“Everyone knows you are playing with fire with leverage,” said Michael Terwilliger, a portfolio manager at Resource Credit Income Fund. “Response to the last panic has built the new panic.”
After years of relatively sedate markets, trades are suddenly getting tested by the Covid-19 pandemic. Emergency measures to contain the virus’s spread are slamming the brakes on commerce, shutting businesses and leaving millions of Americans jobless. The economic downturn is raising the prospect that consumers and companies will fall behind, defaulting on loans.
A slump in prices for risky debt is putting pressure on investors to pony up collateral or unwind leveraged trades. That feeds a vicious cycle, with rapid liquidations depressing prices further, potentially triggering more margin calls and sales. It’s contributed to violent drops in the market.
Still, there’s scant evidence to suggest the amount of leverage in the system now is as great as it was heading into 2008.
There are few if any public disclosures outlining the magnitude and structures of many leveraged trades. Market insiders and people with knowledge of transactions that unraveled agreed to describe what they have seen on the condition of anonymity.
Swaps
Citigroup and Truist Financial Corp. had to sell off hundreds of millions of dollars in risky credit known as leveraged loans, after prices on the debt collapsed to 10-year lows. The loans were behind total-return swaps, a type of derivative that gives investors amplified exposure to a debt’s performance.
In a typical arrangement, the client pays the bank an agreed-upon rate and in return receives payments based on the performance of the asset without actually owning it. The swaps have mark-to-market triggers that enable banks to demand more collateral if prices fall below a certain level. Depending on how the deal is set up, the assets may be sold.