Federal Reserve Prepares for Another Hedge Fund Bailout
In September 2019, the Federal Reserve's aggressive tightening caused a sudden and severe liquidity crisis, triggering what became known as the "repocalypse." This event sent overnight rates soaring and crushed leveraged Treasury cash-swap pair trades, commonly referred to as basis trades. The world's largest multi-strategy hedge funds, including Citadel, Millennium, and Balyasny, which had significant exposure to these trades, faced the threat of collapse. This critical situation was analyzed in December 2019 in an article titled "The Fed Was Suddenly Facing Multiple LTCMs."
A few months later, the same hedge funds were hit by the combined effects of the COVID-19 market crash, pushing the financial system to the brink. Without the Federal Reserve's intervention through unlimited multi-trillion-dollar repo operations and a massive $100 billion-plus monthly quantitative easing (QE) program, the entire financial system could have imploded. Even Bloomberg later acknowledged this reality. As the global economy shut down due to COVID-19, an analysis titled "Fed Bailed Out Hedge Funds Facing Basis Trade Disaster" explained how major hedge funds, including Millennium, Citadel, and Point72, were deeply entrenched in the repo market and among the most leveraged multi-strategy funds globally. These firms leveraged net assets under management of $20-$30 billion up to $200 billion using repo transactions.
Mark Yusko, CEO of Morgan Creek, highlighted the systemic risk, stating that financial institutions had become "too big to fail," but this time it wasn't just banks—it was highly leveraged hedge funds. He pointed out that while he supported the Fed's intervention, the excessive borrowing by hedge funds had made them dangerously large. This echoed sentiments expressed months earlier, reinforcing the notion that the Fed's actions amounted to a bailout.
This bailout, however, was concealed within the broader economic turmoil of the COVID-19 crash. As the Treasury and the Fed injected trillions into the financial system, other global economies followed suit. These extraordinary interventions laid the groundwork for the highest inflation levels in half a century. Despite the upheaval, nearly six years after the first basis trade meltdown, little has changed. Over time, several significant events underscored this recurring pattern.
Today, the financial landscape is bracing for another hedge fund bailout. Bloomberg reports that a panel of financial experts has advised the Fed to establish an emergency program to unwind highly leveraged hedge fund trades should a crisis erupt in the $29 trillion U.S. Treasuries market. These experts warn that the unwinding of approximately $1 trillion in hedge fund arbitrage bets could destabilize not just the Treasuries market but other sectors as well, necessitating Fed intervention to maintain financial stability. In March 2020, when the Fed last took similar action, it executed massive Treasury security purchases, injecting around $1.6 trillion over several weeks.
Since the Federal Reserve lacks regulatory control over multi-billionaire hedge fund managers and their risk-taking strategies, the proposed solution appears to be preparing trillions in taxpayer funds for another large-scale bailout. This would ensure that hedge fund billionaires continue their operations without facing the consequences of their high-risk trades.
For those curious about the entities behind these basis trades, a chart of hedge fund leverage among the six largest multi-strategy funds provides insight. The "Big 6"—Millennium, Citadel, Balyasny, Point72, ExodusPoint, and Lighthouse—collectively hold a record regulatory capital of $1.5 trillion, marking a $300 billion increase from the previous year. More concerning is the surge in average regulatory leverage, which has climbed to 7.8 times assets under management, up from 6.3 times the previous year.
A collapse in the $1 trillion basis trade would likely trigger a Fed bailout due to the extreme leverage inherent in these trades. Leveraging long cash positions while shorting futures involves ratios ranging from 20 times, as estimated by the Treasury Borrowing Advisory Committee, to as high as 56 times, according to the Federal Reserve itself.
Against this backdrop, discussions about the next hedge fund bailout are already underway. Bloomberg reports that a proposed intervention could involve hedged bond purchases. A Brookings Institution paper by financial experts from the University of Chicago, Harvard, Columbia, and Harvard Business School suggests that if the Fed intervenes again, it should do so on a hedged basis. Jeremy Stein, a former Fed governor, emphasized that this approach could be a valuable addition to the Fed's policy toolkit.
The primary risk, as documented by financial analysts for years, is the basis trade itself. This strategy involves hedge funds profiting from minute price gaps between Treasuries and futures derivatives. Experts note that only a small group of hedge funds—perhaps fewer than ten—dominate this trade. If these funds need to unwind their basis trade positions quickly, as they did in September 2019 and March 2020, the impact could overwhelm bond dealers. The severity of the situation is even greater today, as the total basis trade exposure has doubled from $500 billion in 2020 to approximately $1 trillion today.
To mitigate the strain on dealers, the proposed plan suggests that the Fed step in to absorb these trades, purchasing Treasury securities and hedging them with an offsetting sale of futures. While this approach could relieve short-term market stress, it inevitably raises concerns about moral hazard. The historical precedent of Fed bailouts—including those following the LTCM collapse, the 2019 repocalypse, and the COVID-19 market crash—suggests that such interventions encourage reckless risk-taking by hedge funds, knowing they can rely on government support.
Stein acknowledged the dilemma, stating that the alternative should not be viewed as "no moral hazard" but rather as an inevitable trade-off. The 2020 bailout, which involved outright Treasury purchases, is already part of the Fed's historical playbook. Traditional QE operations blur the line between financial stability efforts and monetary policy, as bond purchases affect long-term yields and influence economic conditions. Additionally, large-scale Fed purchases reduce remittances to the Treasury, complicating fiscal policy.
Ironically, the Fed is still unwinding its 2020-2022 QE-driven bond purchases—bailouts that primarily benefited billionaire hedge funds. While hedged bond purchases could serve as a self-liquidating strategy, removing concerns over long-term bond sales and future tightening cycles, they do not eliminate the fundamental risks. The next financial crisis is not a matter of if but when, and when it arrives, the Fed will likely resort to traditional QE once again. Attempting to substitute it with a sterilized, "hedged" approach is unlikely to carry the same impact, especially in a rapidly deteriorating market.
The authors of the Brookings Institution paper argue that a basis purchase facility wouldn't be significantly different from the Fed's existing open market operations. Since basis trades involve simultaneous spot purchases and future sales, they bear conceptual similarities to repo transactions. However, there is a crucial distinction: repo transactions are widely utilized across the market, whereas basis trades primarily benefit a handful of hedge funds engaged in highly leveraged risk-taking.
Placing taxpayers on the hook for inevitable losses stemming from these trades is a controversial proposition. While policymakers have considered various measures to enhance Treasury market stability—including regulatory adjustments for bank dealer capacity, the establishment of a Standing Repo Facility, and imposing minimum margin requirements for repo-financed Treasury purchases—the underlying issue remains unchecked. A new mandate for central clearing of Treasuries and repo transactions is set to take effect on December 31, 2026, but whether it will effectively mitigate systemic risk remains uncertain.
Hedge funds are operating in a highly aggressive environment, where even minor fluctuations in basis spreads could force them out of their positions. Given the current market structure, dealers are ill-equipped to handle a large-scale unwind of leveraged trades. Financial analysts have long warned about this scenario, and now, as discussions of the next bailout intensify, the systemic risks remain as pronounced as ever.
The financial system is once again at a crossroads, with hedge funds placing enormous leveraged bets on the assumption that, in times of crisis, the Fed will step in to rescue them. As history has repeatedly shown, such interventions create a cycle where risks escalate unchecked, setting the stage for the next financial upheaval. While policymakers explore alternatives, the reality is that when the moment of reckoning arrives, the Fed's response is likely to follow the same well-trodden path—bailing out hedge funds under the guise of financial stability, with taxpayers ultimately bearing the cost.