New York Fed’s Repo Loans Are Foaming the Hedge Fund Runways

By Pam Martens and Russ Martens: October 30, 2019 ~

Mark Carney, Head of the Bank of England

Mark Carney, Bank of England Governor

There is growing evidence that the New York Fed, the Wall Street feeding tube team of the Federal Reserve Board of Governors, is using its massive new repo loan operations to securities firms (primary dealers) to foam the Wall Street runways to try to avoid a crash landing as money gushes out of hedge funds by the tens of billions of dollars.

According to a report at eVestment, investors pulled $29.37 billion from hedge funds in the third quarter of this year, bringing the total year-to-date to an eyebrow-raising $76.86 billion. That’s more than twice the amount that was withdrawn in all of last year. Hedge funds are highly-leveraged, so $76.86 billion in withdrawals could translate into hundreds of billions of dollars of liquidations in stock and bond markets. The report further notes that this is the “sixth consecutive quarterly outflow.”

Supporting the thesis that a surge in hedge fund withdrawals at least partly explains the liquidity crisis on Wall Street that has prompted the Fed to restore its money funnel, the Financial Times reported on October 1 that the CFO of a “top-10 US bank” told it that “We have plenty of liquidity. We are just choosing not to lend it out overnight to hedge funds.”

What may be weighing on bank fears about hedge funds and mutual funds holding illiquid assets are several high-profile flameouts over the past year.

On June 3 the highly-touted $4.7 billion Woodford Equity Income Fund in the U.K. froze withdrawals by investors. The fund was slated to reopen for withdrawals in December but now the U.K. regulator, the Financial Conduct Authority (FCA), is reporting that the fund will not reopen and will be liquidated instead. Investors will receive their pro-rata share of the liquidations in installments – with no firm timeline given. The FCA has an ongoing investigation into the matter. The problem, according to the FCA, is that the fund was holding illiquid and hard to price assets.

Something very similar happened at GAM, a Swiss asset management firm, last year. On July 31, 2018 GAM announced it had launched an investigation of its investment director, Tim Haywood, and had placed him on suspension. That announcement was followed a few days later with the news that the unconstrained/absolute return bond funds that Haywood managed were suspending withdrawals. That announcement was also later updated to say that the funds would be liquidated. It took approximately one year for investors to get the last of their proceeds from the fund. Haywood was fired from GAM in February of this year for “gross misconduct.” It has been reported that he also had gorged on illiquid bonds.

Just this month, South Korea’s biggest hedge fund, Lime Asset Management, announced that it was halting withdrawals on some $700 million of funds. The problem with Lime is also reported to be illiquid assets, particularly convertible bonds.

Mark Carney, Governor of the Bank of England, told a committee in the U.K. parliament in June that funds holding illiquid assets could pose a systemic risk. Carney stated:

“These funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid.”

Those chickens are now coming home to roost, just as they did in the runup to the financial crisis in 2007.

Wall Street veterans will recall that the 2008 financial collapse had early warning signs from highly-leveraged funds the prior year. On June 7, 2007, the U.S. investment bank, Bear Stearns, quietly sent a letter to investors in its High-Grade Structured Credit Strategies Enhanced Leverage Fund, advising that it was suspending withdrawals because the “investment manager believes the company will not have sufficient liquid assets to pay investors.”

In July of 2007, Bear Stearns updated that missive as well as to a sister fund, advising that there was “effectively no value left” in the first fund and “very little value left” in the second fund. Both funds had gorged on bonds and/or derivatives related to the subprime mortgage market.

In August of 2007, BNP Paribas, the large French bank, announced it was freezing withdrawals at three of its funds with a total of $2.2 billion in investments.

If the New York Fed is willfully foaming the runways for Wall Street to cushion the unwinding of illiquid assets at hedge funds to meet withdrawal requests, it would not be the first time that there has been a surreptitious foaming of the runways for Wall Street hubris. (It’s fairly safe to assume that Wall Street investment banks created the illiquid assets that are now clogging the financial plumbing at hedge funds and mutual funds just as their subprime securitizations blew up the Street in 2008.)

There are two very dark and disturbing paragraphs in Neil Barofsky’s 2012 book, Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street. Barofsky was the Special Inspector General of the Troubled Asset Relief  Program (TARP), a shiny ($700 billion) object approved by Congress to inject money into Wall Street banks during the financial crisis while distracting the public’s attention away from the secret $29 trillion that the Federal Reserve was pumping into Wall Street banks and their foreign derivative counterparties from December 2007 to the middle of 2010 – without one elected official giving approval or even being aware it was happening. (The Fed lost a multi-year court battle and had to disclose the details and a Government Accountability Office audit of the Fed’s bailout programs provided more details in July 2011.)

According to Barofsky’s account in his book, the Home Affordable Modification Program (HAMP) did not have a primary objective of keeping struggling families and children in their homes. It’s real goal, according to then U.S. Treasury Secretary Tim Geithner, was to “foam the runway” for the banks. Where did Tim Geithner come from? He had been at the helm of the Fed’s Wall Street bailout as President of the New York Fed. He “failed up” to the position of U.S. Treasury Secretary.

Barofsky writes in his book:

“For a good chunk of our allotted meeting time, Elizabeth Warren grilled Geithner about HAMP, barraging him with questions about how the program was going to start helping home owners.  In defense of the program, Geithner finally blurted out, ‘We estimate that they can handle ten million foreclosures, over time,’ referring to the banks. ‘This program will help foam the runway for them.’

“A lightbulb went on for me.  Elizabeth had been challenging Geithner on how the program was going to help home owners, and he had responded by citing how it would help the banks. Geithner apparently looked at HAMP as an aid to the banks, keeping the full flush of foreclosures from hitting the financial system all at the same time.  Though they could handle up to ‘10 million foreclosures’ over time, any more than that, or if the foreclosures were too concentrated, and the losses that the banks might suffer on their first and second mortgages could push them into insolvency, requiring yet another round of TARP bailouts.  So HAMP would ‘foam the runway’ by stretching out the foreclosures, giving the banks more time to absorb losses while the other parts of the bailouts juiced bank profits that could then fill the capital holes created by housing losses.”

It’s long past the time for Congressional hearings on the Fed’s newly constructed money spigot to Wall Street as the U.S. taxpayer is the ultimate backstop for the Fed’s $4 trillion and rapidly growing balance sheet.

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