Leverage: The Double-Edged Sword - The Forecast

Leverage: The Double-Edged Sword

Leverage: The Double-Edged Sword

The massive market correction we just experienced is largely the result of excessive use of leverage from large commercial banks and hedge funds. Fueling the fire is the Repo Market, a source of overnight lending which enables grotesque amounts of leveraged. This repurchasing system is orchestrated by the Federal Reserve to ultimately pump more liquidity into the economy and push asset prices higher. By examining how the Federal Reserve uses the Repo Market to inflate the economy, one can better understand the reasons behind the March crash, along with the inevitable debt bubble that will soon pop.

The Repo Market provides hedge funds and commercial banks with the full power of the Federal Reserve’s printing press. This process begins when the Fed provides loans to commercial banks, (ex. JP Morgan) and these commercial banks subsequently loan that money out to hedge funds. These hedge funds have access to 10x overnight leverage and put this money in government assets like T-Bills, or use it to finance the short-selling of derivatives. While the interest rates on government bonds are but a pittance, over the course of 20 trading days hedge funds skim fractions of a percent off of them.  By utilizing the bulk of their leverage, hedge funds were making millions overnight, with virtually no risk.

An east coast hedge fund, which we will not name, provides a poignant example for the profitability and risk that these large firms undertake.  With approximately 12-13 billion in net assets,  this hedge fund can control between 100-200 billion overnight in Repo money. However, these are loans that require repayment and after overnight assets are sold, interest is collected the next day through repurchase agreements. If the borrower does not have a satisfactory amount of collateral, the Repo Banks will either reduce lending or raise the rate of interest charged overnight. With many institutions holding an incredible amount of questionably-rated corporate bonds, Euro bonds, derivative contracts, etc, the banks have sealed their coffers. They no longer trust the collateral these hedge funds and other banks have in the market, highlighting a lack of confidence in government, corporate, and private debt. Therein lies the crux of the Repo Crisis. Banks don’t trust other banks!

The world is riddled with debt and it is only a matter of time before the debt bubble pops (2024 at the latest). The bottom line is you don’t want to be on the tracks when this freight car comes crashing down. US corporations have issued huge amounts of debt and have used that money to repurchase their former shares – reducing the public float in the marketplace. This has led to excessive stock valuations for their shareholders, and of course, the paychecks executives receive have followed suit. The way stocks are seen has changed. Long gone are the days of looking for companies of sheer value.

Since the Fed recognized this problem back in September 2019 with Repo interest rates skyrocketing to 10% for overnight lending, they were fearful of seeing an economic downturn – especially during the holidays. As a result, they began increasing the amount of money pumped into the Repo Market. It was this practice that would stretch markets too far above the 200 day moving average, triggering a colossal selloff. The coronavirus was merely the straw that broke the camel’s back. Imagine you are firing off a slingshot: The more you stretch the band backwards, the more violent the snap in the other direction becomes. Instead of letting the market pursue its natural price action, the mismanagement of the Repo Market has stretched the rubber band back too far, turning a modest correction into an avalanche.