Every time interest rates get low, crazy leverage works its way into the financial markets. It can take different shapes and varieties, but it pretty much always ends the same way. I’ve traded and structured assets across a ton of markets and geographies over a capital markets career spanning 25+ years. I’ve seen this movie a few times before. What is happening in the Crypto markets today is no different than Long Term Capital Management in 1998 or the credit defaults of 2002 or the mortgage crisis of 2008. In all instances, low yields led to irresponsible risk taking and eventual forced liquidations.
Let’s start with the leveraged trading strategies at Long Term Capital Management (“LTCM”) from 1998. LTCM was founded in 1994 by John Merriwether, a titan in the bond markets from Salomon Brothers, with famed economists Myron Scholes and Robert Merton on their Board of Directors. The firm started right after the Fed Funds rate had been lowered from nearly 10% in the late 1980s to a low of 3% in 1993. They grew assets quickly to over $1Bn while specializing in fixed income arbitrage. LTCM made very large bets on the shape of the yield curve or the relationship between similar bonds. They used an excessive amount of leverage from their bank partners to make these bets. LTCM wasn’t the only hedge fund that made these bets, tons of copycats emerged, and leverage ballooned across the bond market. When Russia defaulted on its debt in 1998, the relative prices of various bonds began to diverge, and things got mess quick. Small price moves led to huge losses for the fixed income arbitrage industry given the massive amount of leverage in the system, and LTCM had to be bailed out by a consortium of their bank lenders. They weren’t the only one. I was working at Bank of America at the time, and our trading group took over the fixed income arb positions from another failed hedge fund. As these trades unraveled, more entities were forced by their creditors or investors to liquidate, pushing the prices to levels no one would have fathomed possible before. It took months for the markets to settle once the assets had been moved to stronger hands.
Interest rates stayed somewhat elevated after the markets calmed down from the 1998 troubles with the Fed Funds rate hovering in the 5% range through the end of 2000. This period led to a significant amount of leverage working its way into the investment grade corporate bond market. Specifically large amounts of money were borrowed in the telecom space as the internet was just getting started and the world was beginning to come online. The tech bubble also inflated stock prices, which burst in 2000. The evaporation of many tech companies led to a drop in revenue of the service providers to the industry and kicked off a round of corporate bond defaults in 2001 and 2002. The economic downturn was accelerated by the events of September 11, 2001. WorldCom, Adelphia Communications, NTL, United Globalcom, Global Crossing, and more defaulted on tens of billions of dollars of debt. These companies took on excessive balance sheet leverage and couldn’t make their bond payments. Spreads on investment grade and high yield corporate bonds gapped wider as investors sold positions in the scary market conditions. It took nearly a year for things to settle in. I was running a chunk of the bond business for Bank of America in Europe as this was happening, I saw up close how the banking system suffered.
The Fed Funds rate was lowered in response to the downturn in 2001/02 to a low of 1% in 2004. This kicked off another round of irresponsible leverage in the bond markets, this time in the mortgage sector. Lending standards got far too loose, and amazing amounts of leverage were placed on low interest rate loans to juice returns for yield hungry investors. The Federal Reserve was too slow to raise rates and lax regulation and poor judgement by the credit rating agencies allowed greedy bankers to push this to obscene levels. When the real estate bubble burst in 2008, overly leveraged institutions like Lehman Brothers, Bear Stearns, Merrill Lynch, Wachovia, and many more were dangerously undercapitalized. Some survived, some were forced to merge with stronger partners, and others were forced out of business. These market moves led to mass liquidation of mortgage positions and eventually spilled over into other markets like bank preferreds and corporate bonds. The crazy leverage in the system had spawned new investment vehicles who became forced sellers in the downturn. Hedge funds failed and sold assets. Banks ran into regulatory trouble and also sold or were closed. The disruption from the unwinding of these positions took years to sort itself out. At that time, I was in the structured products group at Wachovia. My boss ran the CDO business, and we were right next to the MBS group. I had a front row seat to the carnage in these markets.
This takes us to the current challenges in the Crypto markets. The Fed Funds rate spent over 5 years near 0% following the mortgage crisis before reaching 2% in 2019. When COVID hit, the Fed jumped into high gear, quickly lowering the funds rate back near zero and providing unprecedented liquidity buy purchasing massive amounts of debt securities. Where did the excessive risk taking go this time? It went to all kinds of asset bubbles. Everything from tech stocks to Crypto to baseball cards hit crazy valuations in 2021. Then the Fed began to reduce liquidity and raise the funds rate, Russia invaded Ukraine, and COVID showed it would be around for years. Markets quickly collapsed.
What we are seeing now in the Crypto sector is that there was a ton of leverage that is now being unwound. It started with Terra/Luna, who took stablecoin investor money and used it to speculate on a range of Cryptocurrencies. It spread to BlockFi, who allowed investors with Crypto to borrow against their positions so they could buy more Crypto. It worked its way to Three Arrows Capital, a hedge fund that used borrowed money to get long Crypto. In past downturns, the leverage mostly came from regulated bank entities. This allowed for an orderly and quick liquidation as regulators eventually acted. This time will be different since banks in most major countries have avoided the Crypto industry. The leverage today is from private investors, both funds and individuals. There is no regulator to step in and force the end of irresponsible lending here. A lot of the forced selling is coming from smart contracts that had built in overcollateralization triggers based on Crypto prices. I think this means that the liquidation process will take longer this time. It also means that there is not good reporting about the amount of risk in the system since there is no regulatory entity trying to pull everything together into a coherent picture. My guess is this means more price risk for the Crypto markets as these liquidations continue for a good chunk of the rest of 2022, but it’s tough to tell where the risks lie in this market. We’ll see how things play out over the coming months.
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