Hedge funds were hammered last month by movements in the treasury market that derailed a popular strategy. The maneuver uses money borrowed from pension markets to exploit differences between cash and futures. Some companies would have raised bets up to 50 times, people familiar with the situation told Bloomberg. According to JPMorgan strategists, leveraged funds could be committed to the so-called core strategy as high as $650 billion. Citigroup and Truist Financial Corp. had to sell hundreds of millions of dollars in risky loans, known as third-party loans, after the price of debt fell to a 10-year low. Loans have been supported by total return swaps, a kind of slippage that gives investors an increased commitment to debt performance. Within a few days, a number of trades unravelled to unmask different forms of acid lever games in their hearts. Citigroup Inc.
was among the banks that attempted to sell $1.3 billion in subprime loans to make bets by debt-financed clients. Funds borrowing to top up mortgage bonds have fuelled a flood of liquidations. Even large municipal debt funds sell billions of dollars in positions. « Everyone knows you`re playing with fire with leverage, » says Michael Terwilliger, portfolio manager at the Resource Income Fund. « The reaction to the last panic created a new panic. » Banks can ask for more cash or guarantees and increase the repo-spread they require when the market becomes acidic. In addition, banks have a much higher cost of capital than in 2008 and, in the midst of a market surge such as March, these securitized products may prove too heavy for many traders. That`s part of the reason why banks have issued marginal calls so quickly this time. When the market value of securities declines — as ESO or RMBS did during the March turbulence — banks become vulnerable to this price drop and ask the hedge fund to make up for the difference. Funds can either provide more collateral or the bank must liquidate the position completely. Forced sales of margin-calls can drive down prices, and these fire prices become publicly available and create lower price points in the market. This triggers a new cycle of margin calls and fire sales at lower prices — a cycle seen since the 2008 financial crisis. After years at record levels, some investors – particularly hedge funds, structured credit funds and mortgage funds — have tried to boost their returns by buying securitized debt through so-called buyback or repo agreements with banks that were their counterparts.
It is a kind of short-term financing that has allowed the funds to increase their returns for these complex and often illiquid securities. But while leverage generates higher profits in good economic times, it can also increase losses in the event of a downturn. The bank charges the asset manager a spread known as « repo, » which represents his profit from the transaction.