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Before Fed Acted, Leverage Burned Hedge Funds in Treasury Market

Sonali Basak, Liz Capo McCormick, Donal Griffin and Hema Parmar
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(Bloomberg) -- When coronavirus panic kicked off unprecedented turmoil in Treasuries last week, hedge fund leverage was lurking.

The firms use borrowed money from the repurchase market for the popular basis trade, which exploits price differences between cash Treasuries and futures. Though individual firms’ borrowing is a closely guarded metric, people familiar with the transactions said some of them levered up as much as 50 times their own wagers. Leveraged funds’ exposure to the basis strategy could be as much as $650 billion, JPMorgan Chase & Co. strategists said.

Investors seeking safety rushed into Treasury futures on March 12, and hedge funds got hammered. A difficulty in completing trades ensued, and was a contributing factor to the Federal Reserve’s decision to pledge $5 trillion to keep markets running smoothly.

High leverage amplifies profits and losses and can be responsible for forced liquidations -- and market fluctuations. This week, a sell-off in Treasury futures tied to margin calls pushed outstanding contracts to their lowest level since 2018. Many firms also get funding from money markets, whose problems have prompted the Fed to provide emergency funding.

Hedge funds’ excessive leverage has contributed in the past to congestion in the typically smooth Treasury market, according to a December report from the Bank of International Settlements, and bank traders have blamed hedge funds in the basis trade for continued issues in repo markets, especially after lending rates spiked in September to 10% from about 2%.

Treasuries Downdraft

“Too big to fail is back, and this time it’s not the banks, it’s levered financial institutions,” said Mark Yusko, the chief executive officer of Morgan Creek Capital. Yusko said he supported the Fed’s stepping in, but added that hedge fund firms have gotten too big by borrowing too much. “It’s a bailout,” Yusko said of the Fed’s actions.

Smaller firms got caught in the Treasuries downdraft.

ExodusPoint Capital Management lost 4% this month through March 13, on pace for its worst month ever, according to people familiar with the situation. It was unclear how much the basis trade contributed to the loss.

An LMR Partners’ fund fell 12.5% in the first two weeks of this month and spurred the firm to raise new capital.

Capula Investment Management’s Global Relative Value Fund dropped 5.2%, people said, and Field Street Capital Management’s fixed-income relative-value flagship fund, in which the basis trade is substantial, sank 14.5% and had to reduce the size of its positions.

The firms declined to comment.

If the declines appear meager compared with losses in stocks and oil, to name two assets with historic plunges, consider that for years, the basis trade earned such steady gains that traders mocked it as lazy.

Perfect Paradise

“We’ve had 10 years of a perfect paradise and so people have been picking up pennies thinking there’s no risk in holding strategies like the basis trade,” said Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group. “A lot of the strategies, like the basis, that hedge funds tend to use don’t work when markets aren’t stable. You’ll see more of these types of blowouts.”

Treasury Futures Domino That Helped Drive Fed’s $5 Trillion Repo

Other firms fared better, according to people familiar with their operations. The market unwind had a relatively small impact on multi-strategy funds Citadel and Millennium Management, the people said, though Millennium is closing several “trading pods” after weathering a 2.7% slump this month through March 12. Millennium was down 1.9% for the year. The firms declined to comment.

Multi-strategy funds sold their positions after they sustained small losses last week, according to a person familiar with the market who was speaking generally and not specifically about particular hedge funds. That led to steeper deficits for firms more focused on the basis trade, the person said.

JPMorgan, Goldman Sachs Group Inc., Barclays Plc and BNP Paribas SA are among the world’s top repurchase lenders, according to regulatory data. The banks declined to comment.

BlueCrest Shrinks From Relative-Value Trades Amid Losses, Exits

Raymond Wang of BlueCrest Capital Management was dismissed March 9 after he couldn’t find a buyer for the investment firm’s losing positions in the basis trade. They were paper losses, according to a person familiar with the situation, because the futures contract hadn’t reached the expiration date before which Wang might have sold the position and made money. If BlueCrest were able to hang on to the future contract it’s possible the firm could’ve come out ahead on the trade, the person said. The firm declined to comment.

The next expiration date for some Treasury futures is March 31.

(Adds Millennium’s year-to-date performance in 14th paragraph. An earlier version of the story erroneously said Mark Yusko invested in Citadel.)

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