Critical response
14 April 2020
Today’s economic turmoil is very different to the previous crisis, but there are still lessons from 2008 that can be applied now
Image: Shutterstock
The world has changed. The word ‘unprecedented’ does not seem quite strong enough to describe the times we are living and working through now, and it is also only partly true. While the cause of the current crisis is new, the response from the financial markets and those that manage and regulate it, is certainly not without precedent.
Consider the last major financial crisis, one so dramatic in its impact and reach that it is simply referred to as “the financial crisis,” eclipsing the depression of the 1930s and other crises since. While the defining moment of the crisis was financial, in the collapse of Lehman Brothers, as opposed to an environmental virus affecting human health, namely COVID-19 or the coronavirus disease, the responses from and impact on many quarters has been remarkably similar.
The immediate impact of the Lehman Brothers default was measured in a matter of days, yet the impact of that single event still affects the markets and regulations as we see them today. With COVID-19, the financial contagion was much slower to spread across the world. This can be largely explained by the more easily quantifiable and understood near instantaneous impact of a major bank failure, compared with the relatively unknown potential for virus contagion across humans originating in a little-known part of the world. Once the true potential impact became more obvious, the ripple effect quickly became a tsunami crossing the world.
Both crises have caused a rush to quality and a shedding of risk assets as markets around the globe plunged, with some close to eroding the whole of the post-financial crisis bull run period. Markets across the world demonstrated a master-class in proving that uncertainty is one of the biggest threats stock markets face. Prime money fund assets in the US plunged by 11 percent in the second week of March, having varied by little more than 1 percent over the prior three months, with investment rushing towards government-issued securities and other safe-haven assets. The rush to quality had begun, just as equities were sold off significantly and treasuries were bought up as Lehman Brothers folded.
While this is a somewhat predictable response from investors, its impact on the securities finance industry cannot be considered in isolation as governments and central banks around the world employ fiscal and monetary policy responses to the unfolding crisis. Lowering of central bank interest rates to historical lows as well as extensive support for industries have been used in conjunction with significant quantitative easing actions. This has been employed most notably by the US government which launched a package of measures totalling some $2.2 trillion designed to support the economy during these uncertain times.
Buying up US treasuries, as the European Central Bank (ECB) found previously with Eurobonds, has a potential to create unintended consequences that can harm some parts of the market while helping others. The US action, designed to spur economic growth through increasing the money supply and thereby making it easier for businesses to borrow money, is undertaken by “buying” mortgage-backed and US Treasury securities from member banks, providing them with credits in return. It is understood that the US Federal Reserve plans to purchase up to $500 billion of US treasuries and up to $200 billion of mortgage-backed securities over the coming months.
However, taking these assets effectively out of circulation can harm those organisations that need to borrow them. Data from FIS’ Astec Analytics shows that borrowing of US treasuries increased from around £385 billion at the start of January to a peak of $472 billion in late March, before falling back slightly to around $460 billion at the end of the month. Over the same period, utilisation grew from just under 24 percent to a peak of 28 percent. Adjusting for price appreciation, utilisation grew around 20 percent faster than volume, suggesting the start of a contracting supply base. Indeed, availability of US treasuries peaked at around $1.75 trillion in mid-March, but has since fallen back, dropping some 9 percent to just under $1.6 trillion.
The drop in bank base rates and the reduction in supply both combined with the increased demand to borrow high-quality liquid assets (HQLA), such as US treasuries, to force rebate rates to fall from around 160 basis points at the end of February to just 25 at the end of March. As the Federal Reserve begins buying up bonds, it may well drive supply down by as much as 30 percent, assuming most of its purchased bonds are from lending funds. This would drive utilisation to rise even further and rebates even lower.
The ECB has also launched a quantitative-easing programme, in addition to its Asset Purchasing Programme (APP). This new programme, the Pandemic Emergency Purchase Programme (PEPP), has up to €750 billion at its disposal, and will target the same securities as were eligible under the APP (national, regional and local government bonds as well as certain corporate debt, ranging from one to 30 years maturity). The PEPP will also include Greek government bonds that had previously been excluded. In addition, the assets purchased under the PEPP will be eligible for securities lending operations, potentially easing the supply of euro denominated HQLA in the market.
National governments have also been flexing their bank accounts when it comes to supporting employers and businesses, underwriting wages for both workers and the self-employed. Not everyone is or can be covered; many companies already on the edge have fallen into administration and more will likely follow as the global lockdown continues. Short sellers have been demonised in the press, just as they were during the financial crisis, with short selling bans being put in place by a number of jurisdictions around the world, desperate to be seen to be doing something to shore up their markets. This is despite the abundance of research that proves such moves increase volatility, price bubbles and trading spreads, damaging the very markets they are intended to protect.
If business bankruptcies continue, logic would suggest that there may be enough defaults to begin to threaten the lenders themselves. The extensive support being provided by governments across the globe may be enough to keep us from a bank default and all that might entail, but until then it is important everyone knows where their next piece of collateral is coming from and how expensive it might be to deliver it, and to keep trust flowing around the system as well as HQLAs.
Figure 1
Consider the last major financial crisis, one so dramatic in its impact and reach that it is simply referred to as “the financial crisis,” eclipsing the depression of the 1930s and other crises since. While the defining moment of the crisis was financial, in the collapse of Lehman Brothers, as opposed to an environmental virus affecting human health, namely COVID-19 or the coronavirus disease, the responses from and impact on many quarters has been remarkably similar.
The immediate impact of the Lehman Brothers default was measured in a matter of days, yet the impact of that single event still affects the markets and regulations as we see them today. With COVID-19, the financial contagion was much slower to spread across the world. This can be largely explained by the more easily quantifiable and understood near instantaneous impact of a major bank failure, compared with the relatively unknown potential for virus contagion across humans originating in a little-known part of the world. Once the true potential impact became more obvious, the ripple effect quickly became a tsunami crossing the world.
Both crises have caused a rush to quality and a shedding of risk assets as markets around the globe plunged, with some close to eroding the whole of the post-financial crisis bull run period. Markets across the world demonstrated a master-class in proving that uncertainty is one of the biggest threats stock markets face. Prime money fund assets in the US plunged by 11 percent in the second week of March, having varied by little more than 1 percent over the prior three months, with investment rushing towards government-issued securities and other safe-haven assets. The rush to quality had begun, just as equities were sold off significantly and treasuries were bought up as Lehman Brothers folded.
While this is a somewhat predictable response from investors, its impact on the securities finance industry cannot be considered in isolation as governments and central banks around the world employ fiscal and monetary policy responses to the unfolding crisis. Lowering of central bank interest rates to historical lows as well as extensive support for industries have been used in conjunction with significant quantitative easing actions. This has been employed most notably by the US government which launched a package of measures totalling some $2.2 trillion designed to support the economy during these uncertain times.
Buying up US treasuries, as the European Central Bank (ECB) found previously with Eurobonds, has a potential to create unintended consequences that can harm some parts of the market while helping others. The US action, designed to spur economic growth through increasing the money supply and thereby making it easier for businesses to borrow money, is undertaken by “buying” mortgage-backed and US Treasury securities from member banks, providing them with credits in return. It is understood that the US Federal Reserve plans to purchase up to $500 billion of US treasuries and up to $200 billion of mortgage-backed securities over the coming months.
However, taking these assets effectively out of circulation can harm those organisations that need to borrow them. Data from FIS’ Astec Analytics shows that borrowing of US treasuries increased from around £385 billion at the start of January to a peak of $472 billion in late March, before falling back slightly to around $460 billion at the end of the month. Over the same period, utilisation grew from just under 24 percent to a peak of 28 percent. Adjusting for price appreciation, utilisation grew around 20 percent faster than volume, suggesting the start of a contracting supply base. Indeed, availability of US treasuries peaked at around $1.75 trillion in mid-March, but has since fallen back, dropping some 9 percent to just under $1.6 trillion.
The drop in bank base rates and the reduction in supply both combined with the increased demand to borrow high-quality liquid assets (HQLA), such as US treasuries, to force rebate rates to fall from around 160 basis points at the end of February to just 25 at the end of March. As the Federal Reserve begins buying up bonds, it may well drive supply down by as much as 30 percent, assuming most of its purchased bonds are from lending funds. This would drive utilisation to rise even further and rebates even lower.
The ECB has also launched a quantitative-easing programme, in addition to its Asset Purchasing Programme (APP). This new programme, the Pandemic Emergency Purchase Programme (PEPP), has up to €750 billion at its disposal, and will target the same securities as were eligible under the APP (national, regional and local government bonds as well as certain corporate debt, ranging from one to 30 years maturity). The PEPP will also include Greek government bonds that had previously been excluded. In addition, the assets purchased under the PEPP will be eligible for securities lending operations, potentially easing the supply of euro denominated HQLA in the market.
National governments have also been flexing their bank accounts when it comes to supporting employers and businesses, underwriting wages for both workers and the self-employed. Not everyone is or can be covered; many companies already on the edge have fallen into administration and more will likely follow as the global lockdown continues. Short sellers have been demonised in the press, just as they were during the financial crisis, with short selling bans being put in place by a number of jurisdictions around the world, desperate to be seen to be doing something to shore up their markets. This is despite the abundance of research that proves such moves increase volatility, price bubbles and trading spreads, damaging the very markets they are intended to protect.
If business bankruptcies continue, logic would suggest that there may be enough defaults to begin to threaten the lenders themselves. The extensive support being provided by governments across the globe may be enough to keep us from a bank default and all that might entail, but until then it is important everyone knows where their next piece of collateral is coming from and how expensive it might be to deliver it, and to keep trust flowing around the system as well as HQLAs.
Figure 1
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