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Why the Financial System could collapse

When we think about recessions, the first thought that pops up in our minds is probably the 2008 financial crisis, when some of the world’s largest financial institutions were bailed out by governments to prevent the global financial system from completely collapsing. However, it is a common belief that since the Dodd-Frank Wall Street Reform and Consumer Protection Act, in 2010, the financial system is much more stable, and far from the risk of collapsing in a domino effect like in 2008. In this in-depth report, we are going to show why the world’s major financial institutions may be in much worse financial positions than we think, posing a threat to the stability of the global economy at the moment we need it the most. In fact, it’s not too much of a leap to say that the structural problems of the financial system haven’t been fixed, but only covered by incredible amounts of liquidity pumped into the system by the Federal Reserve. In order to understand the causes that could lead to the next crisis, we first need to go back in time and look at what triggered the previous ones.

The untold crisis: the 2019 Repo Market meltdown

For those who don’t know how the repo (Repurchase Agreement) market works, it’s basically a short-term loan market, where hedge funds exchange bonds for cash, and promise to buy back those bonds later, at a higher price. This type of transaction can involve two parties (bilateral repo transaction) or three parties (triparty repo transaction).

September 17, 2019: the overnight repo rate suddenly goes from 2% to 10%. A combination of large amounts of liquidity demanded by banks and new government bonds flooding the market creates panic among financial institutions, which are not willing to lend money anymore. Also, this happens just when the Federal Reserve started tapering Quantitative Easing and selling off its balance sheet. Normally, these events represent an opportunity for banks, since they can lend some extra funds to profit from higher rates; but as stated by Jamie Dimon, head of JP Morgan Chase & Co (the biggest bank in the US), banks had “tied hands”, because they were struggling to meet capital requirements. This shows the fragility of the repo market, which is almost entirely dependent on the biggest financial institutions. We should not forget that the failure of Lehman Brothers in 2008 generated the chain reaction in the repo market which led to the global crisis and was caused by the multiple lending of the same collateral. So, what did the Federal Reserve do on September 17, 2019?

They pumped in 100 billion dollars in overnight repo liquidity, buying up all the bonds the banks could not sell. It was followed by the Fed announcing an “Increase in temporary liquidity” available to markets, but they never stopped.

US overnight repo rate, 2014-2019

March 2020: The forgotten financial crisis

In March 2020 the US treasury market broke down. What is considered by many investors as the safest asset class in the world and bedrock of the bond market, was dumped by panicked investors trying to collect cash, which didn’t happen even in 2008. On March 15 the Federal Reserve did something unprecedented, by announcing it would buy $500 billion of government bonds and $200 billion in mortgage-backed securities. However, this didn’t stop the stock market and money market from plummeting, which led the Federal Reserve to announce “QE infinity” on March 24. While investors cheered, they didn’t realize that unlimited government bond purchasing, funded by money printing, is impossible. An unlimited supply of money would make the currency worthless, which is the reason why a growing number of economists think the dollar will lose much of its current value, and eventually its “world’s reserve” status. Estimates show that the Fed has injected approximately $9 trillion since September 2019, creating about 22% of all the dollars issued since the birth of the USA. But, going back to the repo market, in March 2020 the Federal Reserve started offering $1 trillion in daily overnight repo (10 times what it offered in September), $500 billion in one-month repo, and $500 billion in three-month repo.

On April 9, 2021, the Federal Reserve announced that it would backstop up to $750 billion in corporate debt, in addition to the $1 billion of commercial mortgage-backed securities announced on March 27th, 2020. But how is it possible that a central bank has bought billions of dollars of corporate bonds? Normally, they would not be allowed to, but they did it by getting special permissions from congress. Apart from the devastating effects of the pandemic, current amounts of money creation, and the Federal Reserve’s Balance Sheet expanding from 4 to $8 trillion within 12 months, might be the sign that there’s something broken in the money market. So, how strong are the banks today?

Derivatives to Assets ratio of the five biggest banks in the US (2021)

Total derivatives held by US banks (2021)

Alarming levels of derivatives

Goldman Sachs currently has $271 billion in assets and holds $42 trillion in total gross derivatives, meaning that it’s leveraged 154 to 1. Citibank, JP Morgan, Bank of America, and Wells Fargo are also highly leveraged, holding $108 trillion in derivatives combined (Source: Office of the Comptroller of the Currency, March 2021). US banks officially had a total amount of $163.8 trillion of derivatives at the end of 2020. In addition to that, record-high amounts of margin debt in the stock market, and an all-time high housing market filled with speculation, show that we might be dancing a knife’s edge right now. The case of the speculative hedge fund Archegos, officially a family office, is shocking, to say the least, and might be the tip of the iceberg: The fund was believed to have around $10 billion in assets, yet was allowed to bet on $100 billion of stocks, defaulting and subsequently generating losses for many banks, among which Credit Suisse, that lost $5.5 billion.

Our conclusion

Extremely loose monetary policies, $9 trillion dollar injections, and speculative behavior sent the stock market and the housing market into bubble territory. However, multiple failures in the repo market and highly leveraged financial institutions represent a big risk for the existence of the banks themselves, as for the stability of the global financial system. Meanwhile, inflation is running hot, very hot, as a natural consequence of increased money supply (See: Hyperinflation is already here: stock market crash is inevitable), which means that the Fed’s ability to support the economy in a future crisis might be limited or would come with horrible consequences for the value of the dollar. As always, the average taxpayer would have to pay for the bank’s recklessness, either through taxes or inflation. Stay tuned and SUBSCRIBE to become a MarketsTalk member and get free access to discussions!

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