Unpacking a Crisis -- The Financial Fallout of COVID-19
An Overview of the Ongoing Chaos for the Curious
Once again, the mainstream media has proved its unfailing incompetence.
Following headlines of “It’s just the flu” and admonishing the tech community for raising fears of the exponential growth of a multiplicative disease, citizens are left holding the bag of a viral pandemic and severe economic fallout.
A delayed response by many world governments to the COVID-19 pandemic was realized about as quickly as outlets like CNN and Buzzfeed deleted their “It’s just the flu” articles. And verified Twitter blue checkmarks continue their moral dictations to the public for calling COVID-19 the Wuhan Coronavirus.
Meanwhile, the fragilities of the financial system that perma bears, Fed haters, bitcoiners, ZeroHedge, Nassim Taleb and other “quacks” (as the intelligentsia calls them) have been warning against for years were again exposed in disastrous proportions.
Welcome to 2020.
A Brief Synopsis & General Incompetence
When crises emerge, incompetence virtually always gleams through to the limelight. The COVID-19 epidemic is no different.
The picture of COVID-19’s spread is beginning to crystallize. However, its financial impact is subject to more opacity as the modern financial system is highly complex with numerous interdependencies.
For mainstream audiences, my goal of this essay is to provide a synopsis of a string of events that led to the point of the current Fed Bazooka response, and how that interplays with many cracks in the fragile financial system. The financial part of the essay is an overview of the ongoing events, which are not elucidated as well as the COVID-19 scientific and public health response because there are many ongoing ripple effects and moving parts.
I hope it helps some people conceptualize what’s happening behind the scenes when headlines ooze annoying financial terminology. Everything is moving so fast, and it’s hard to keep pace.
We will dive into the financial aspect later, but let’s begin with basic incompetence.
I realize that many people are neither on certain corners of Twitter (e.g., Crypto Twitter) nor interested in exploring obscure Reddit posts about what was actually happening in Wuhan in early January. For the sake of brevity, I will highlight some of the major takeaways as I randomly stumbled into a crypto influencer’s debacle while he was stuck in China during the outbreak and documented what was happening.
This individual was in Wuhan, ground zero for COVID-19, as China’s Communist government began its heavy-handed crackdown as its response to the virus. The initial images shared by him and others on Twitter that could escape the Great Firewall of China painted a devastating scene.
Random people falling on the ground in the street, proceeding to fall into seizures and die. Military guards around hospitals brimming with people screaming and nudging to catch a single word with a medical professional. Mysterious videos of government workers blasting bleach all over streets and buildings. Large outdoor graves of burning bodies at night. Government teams, wearing the Communist red armband, walking around with firearms and barricading and/or welding apartment buildings shut. People forcibly dragged from their homes by the military for posting on social media.
The dystopian list goes on.
I had been sharing these videos and my early research efforts into the crisis with one of my friends, who I don’t blame for thinking I was embroiled in some crazy conspiracy theory. However, my professional background provided some merit to my initial takeaways.
For context, I studied Immunology/Epidemiology as an undergrad and worked for a prominent cancer center as a researcher after graduating. That was years ago, and now I focus primarily on finance, but that’s neither here nor there. I am consistently humbled by the power of mother nature, and for years have feared that a pandemic like COVID-19 may emerge.
Now that it’s here, its consequences worry me more than I had anticipated. Which brings me to the first stage of the ongoing fallout -- general incompetence.
Several weeks after the concerning videos in Wuhan began popping up in other cities in China, a comprehensive lockdown of roughly one-tenth of the entire world’s population, including some of the world’s biggest cities, commenced. Only small peeps about the lockdowns were heard from the media inserted between the topic du jour to be enraged about that day.
For some reason, it appeared that the media believed the Pacific Ocean is some vast moat protecting viruses from China reaching our shores. It’s as if planes, boats, and a progressively global society never existed among globalism’s most ardent supporters.
Soon, tech industry leaders like Balaji Srinivasan began a steady forecast of exponential growth and how today’s global society is highly vulnerable to pandemics like COVID-19. Other prominent figures on social media soon joined him, and an early message about intentionally overreacting to the crisis to mitigate its adverse effects began. Nassim Taleb and several of his randomness buddies were soon propagating a similar message, which may have helped save countless lives.
Guess what the media did?
Vox’s “tech branch” called Recode ran with a story called “No handshakes, please” pulling the usual style of believing everything public officials say and admonishing the tech industry because they have some kind of strange and ongoing beef with each other. Other outlets ran with similar stories, using asinine arguments about COVID-19 being less dangerous than the flu without having a Kindergarten grasp of mathematics or tail risk.
I even talked (casually at local bars) to multiple doctors who told me that I was crazy for being concerned and to keep my nose out of the medical world.
Anyways, once Trump joined the “It’s just the flu” train, everything changed.
In what is quite possibly the funniest thing I have ever seen, I watched in disbelief as media companies, virtually instantly, switched their narratives to be antithetical to Trump. They simply could not accept being in agreement with him on a topic. At the same time, they were playing this bizarre see-saw game of not acquiescing to the outcries of tech circles, playing the ultimate balancing act to sustain their moral high ground from which all their content emanates.
COVID-19 cases began popping up in SE Asian countries around China and a slew of cases in nations like Australia and Iran. Then Italy happened, and we’ve snowballed into, at the time of this writing, roughly 220k cases globally. Europe, especially Italy, Spain, France, and Germany are now the epicenter of COVID-19.
Ironically, Trump had banned incoming travel from China in February, which is right around when the media switched their narrative. Originally they called him racist and xenophobic. Then they said he didn’t do enough a week later.
Once again, the incompetence of the media to persistently maintain a moral high ground in all political (even non-political at this point) topics is inextricably linked to massive public ignorance. Toilet paper in the US began selling out once reports from Italy began sounding eerily similar to Wuhan.
Italy and Iran announced shutdowns, people began getting nervous, COVID-19 became a national talking point, finger-pointing on Twitter started, and the S&P took a meteoric tumble. Now, with the US and much of the world teetering on full-fledged quarantine, the financial fallout is just beginning.
And judging by the jocularity of many people today, they have absolutely no idea about the magnitude of what’s happening behind the financial veil of modern financial infrastructure.
Let’s begin.
No Vacancy, No Liquidity
The modern financial system is like the human body. Complexity, interdependencies, and various systems rely on each other for the whole charade to function without the broader system collapsing. Once a disease strikes a vital organ, collateral effects ensue in other organs or the bloodstream. Same with finance. One system fails, it causes ruptures in another, and the system fluctuates on the verge of collapse without a vaccine or antibiotic.
Mapping out the financial system is an arduous task even for research analysts at Goldman Sachs, let alone fit for a blog post. But I’ll try my best to unpack some of the general interdependencies that are collapsing in a domino-like fashion and why they’re important.
When the human body produces symptoms like a dry cough, fever, or sore throat, they are symptoms of an underlying disease or infection -- such as COVID-19. The same is true with the modern financial system. The massive liquidity crunch, funding market problems, Fed bazooka, collapsing risk-parity and rules-based passive funds, corporate credit bubble, and more are all symptoms of one root cause -- the government’s monopoly over the creation of money.
AKA the Federal Reserve.
The Federal Reserve is the central bank of the United States. With the dollar being the de-facto reserve currency of the world, the Fed can also be considered a central bank to the global financial system in some respects.
I don’t have time to elucidate how the Fed works with the whirlwind of news bombarding my phone every day while I try to push out this piece so I highly recommend one of the following resources below before continuing further in this essay. The first option (YouTube) is recommended for visual learners.
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Overview of International Banking System --
Overview of the Federal Reserve --
Ender’s Game -- A thick primer (deep dive) on Fed activity since the 1970s from Unchained Capital’s Parker Lewis
At this point, the Fed’s entire sideshow is to just supply liquidity to the entire country, and maybe even the world. Liquidity is the ultimate goal of any market. More liquidity, the better. If you can buy an asset, sell it for cash, and buy another asset all within seconds, that’s a brief description of good liquidity.
The problem with liquidity before the crisis is that it was false-flag -- it appeared to exist when it really didn’t. That’s why people refer to the financial system as fragile. The global financial liquidity was akin to stretching a bungee cord to its very limits, then assuming all is well and it will not snap if we extend it further.
Enter leverage.
Leverage is trading on margin. It allows individuals, companies, funds, etc to take a loan from a broker or bank and increase the money being traded. It does not actually increase a financial position’s size but accelerates gains and losses. The problem with leverage is that it is ostensibly another form of debt. Higher leverage equates to higher risk. It pledges money that, for all intents and purposes, does not actually exist. More on that later.
The looming fear of any financial crisis is what’s called a liquidity crunch. Sometimes confined to corners of the market rather than the whole market, liquidity crunches are crisis-induced deleveraging events by major financial players accompanied by widescale liquidation of risky assets. Many parties even liquidate historically non-risky assets to acquire the prize of a liquidity crunch -- the United States Dollar.
Currently, we’re seeing some of the early ripple phases of an unprecedented liquidity crunch. Think of it as the popping of a major asset bubble. That bubble was primarily located in corporate debt and the stock market (equities) but shifted enormous selling pressure to major funds and financial institutions like Citadel and Millennium that are highly leveraged.
But first, some historical caveats.
Following the 2008 Financial Crisis, the government circumscribed the risk-taking of banks with a series of sweeping regulatory reforms (e.g., Dodd-Frank). The decree removed many risky assets from bank balance sheets and, more generally, removed them from a primary role that banks performed within and between different markets -- market-making and arbitrage.
Market making consists of placing bids and asks in an orderbook for various assets across multiple trading venues. Market makers are rewarded by exchanges for their services, which is providing liquidity. Without banks capable of sufficiently providing liquidity where they formerly did, such as levered corporate debt instruments or collateralize-debt obligations (CDOs), the rise of “shadow banks” and bulky passive funds had to fill the role.
Citadel and Millennium fall into the category of institutions that took up the mantle where banks had been jettisoned. Moving away from active trading, many funds fulfilling the market making and liquidity role rely on a passive investing model significantly allocated to low-risk fixed-income products and modern portfolio theory. They look eerily similar to Long-Term Capital Management (LTCM). They are highly leveraged, and are under the general belief that they will get bailed out should things go South, which they are both going South and on the path towards being bailed out by the Fed.
The high leverage in low-risk assets counterbalances a smaller portfolio allocation to asset classes with higher returns and risk than something like government bonds. However, problems always arise with entrenched high leverage positions -- they are fragile to shocks. The description of these funds and “shadow banks” is important to keep in mind. Whereas they are not the spark that lit the fire, they’re the high octane fuel simmering over the kindling.
What was the spark then?
Pathetic cash-flow management by corporations enticed to take out artificially low-interest loans (the Fed’s doing) from commercial banks to buy back their own stocks and enrich shareholders rather than save the money for a rainy day or invest in infrastructure. We’re not just on a rainy day now, it’s hailing with lightning and tornadoes.
Too confusing all up front, I know -- stay with me.
Poor cash-flow management produces a fragile company. Like nature, companies that do not produce more value than they consume should exit the gene pool. Artificially low-interest rates let them hang around interminably. Fragile companies are not robust to shocks. Disruptions, like seven sigma events, which the cool kids call “Black Swans,” are shocks to fragile systems.
COVID-19, a global viral pandemic spreading voraciously around the world and rupturing the fabric of society is about as close as you will get to a White Swan event — one that is drastic yet preventable by preparing accordingly. Corporations seduced by low-interest rates and outsized stock returns in the (seemingly) never-ending bull market since Trump took office were totally oblivious to the consequences of a commercial and supply chain shutdown.
For example, China is the largest manufacturer and exporter in the world. That’s why nearly every physical product you see says “made in China.” Early reports as the Chinese economy resumes a prolonged quarantine shutdown indicate that commercial activity plummeted 15-20 percent. Without diving into that number further, just know that it’s insanely impactful and caused tremendous (some seen, some unseen) effects on global supply chains.
In a global, interconnected world, supply chains are like Christmas lights. They work in tandem or barely work at all.
The ironic aspect of this whole supply chain shock was that it coincided with Russia telling Saudi Arabia and OPEC to bleep off, the Saudis mass-producing oil, and oil prices plummeting as the US Shale industry collapses and needs refinancing. Oil has now fallen off a cliff and is barely clinging to $21. Literally, you cannot make this shit up -- it’s like a perfect storm of White Swan and Black Swans. Crude oil’s price taking a nosedive drives panic. Always has, and probably will for the foreseeable future.
Once oil began its dive, it raised awareness as to some general market uncertainty. This is around the time when the media did the 180 degrees flip “Anti-Trump” narrative of COVID-19 being way worse than the flu. The S&P and other stock indexes began tumbling as corporations either began to realize the gravity of having Kindergarten cash-flow management and a looming global pandemic or were actually hit hard by the supply chain shock.
Either way, the result was the same. Panic selling, liquidations, and margin calls.
Corporate buybacks have a cannibalizing effect on the economy. For instance, buying stocks while pension plan shortfalls balloon. Corporate buybacks are also the dominant source of stock market demand, meaning cessation of low-interest fueled buying by corporations means lower buy-side demand. But COVID-19’s effects didn’t just stop the buying -- it induced selling.
Jesse Livermore is perhaps Wall Street’s most famous investor, known as “The Great Bear of Wall Street.” One of his most salient pieces of advice from his career was never to trust an insider. When corporations have to publicly announce they are not liquidating assets and selling their own stocks, they’re probably liquidating assets and selling their own stocks.
Hence the precipitous drops in the stock market. Incidentally, if we use the Gaussian Model of a normal distribution, the sharp volatility of the S&P 500 in the first two weeks of March were theoretically impossible. You were more likely to catch a lightning bolt while walking on water than have acute volatility spikes at the persistent levels we’ve seen recently. That’s why you don’t trust the Gaussian Model. It appears that corporations did.
Remember those passive funds like Millennium and Citadel?
Well, with high leverage on passive income products and lower leverage on their smaller portfolio allocation, stocks, the rapid selloff and spiking volatility in stocks required them to reduce their risk exposure. This happens through a gradual deleveraging event -- if they haven’t already blown up their funds entirely. Whether risk-parity or rules-based, these funds HAD to deleverage.
A liquidity crunch ensues when these funds, who have virtually replaced banks as market makers and liquidity providers in critical markets, need cash to save their asses. Markets begin to dry up, and basic infrastructure levers start failing.
Government to the rescue!?!? Nope, regulations just get in the way.
By law, the funds and shadow banks cannot directly tap the overnight Repo Funding Market, which is basically a secondary liquidity market for Treasury Notes for banks to uptake cash in a crisis. The Fed Bazooka, which entailed trillions in repo funding, is where the Fed exchanges cash for Treasury Notes with banks. Repo also nebulously is related to the fancy term “open market operations” where the Fed expands its balance sheet by purchasing mortgage-backed securities (MBS).
It gives banks cash reserves so they can stay afloat in times of crisis like a liquidity crunch. And at a high level, all fancy terms that the Fed announces they are executing lead to one outcome -- the expansion of the money supply.
However, the repo offered by the Fed was barely uptaken by commercial banks because they didn’t need the surplus cash reserves and viewed the market making funds as having too high of counterparty risk to lend to.
The massive volatility in the market rippled across all kinds of credit markets, causing the funding rates to go haywire in the Repo Markets. The outcome worsened for the market making funds.
So to recap, the market making/liquidity funds rapidly spiraling into collapse because of high-leverage, Black Swan-prone activity cannot tap into money that the Fed is literally pumping into the Repo Market because of a law that was designed to prevent banks from doing exactly the risky activity that got the funds into trouble now. Irony does not do the situation justice.
At the time of writing (03/18), the Fed announced $1.5 trillion in standing Repo operations for the entire week. Besides how crazy that is, I’m not aware of how this circumvents the crux of the problem, which may come to light soon considering how fast everything is moving right now.
Anyways, with sheer panic reaching a crescendo likely within the next few weeks, the government has decided to inject the Fed’s monetary policy home run swings with fiscal policy steroids. Checks to every citizen, removal of payroll taxes for the year, maybe even no federal income tax for 2019 at this point -- who the fuck knows.
With small businesses around the country closed down, the freezing of the economy will only produce non-linear negative externalities. It’s not like the GDP for the remaining year will predictably decrease at a fixed rate compared to the number of days businesses are closed. The Fed and Trump administration (I hope) seem to be aware of this, hence the Bazooka and fiscal kitchen sink thrown at the current mess.
Now, reviewing everything just described we can take away a specific product of all the chaos -- a surging demand for the United States Dollar. In liquidity crunches, cash is king. Sorry, Ray Dalio.
Cash is king not just in the US either, although the Fed is wont to serve the US economy first. As the liquidity crunch ripples across the world, hitting FX markets, eurodollars, and other instruments linked to major foreign financial institutions, people want to liquidate depreciating assets for cash. Specifically, the USD, which is the reserve currency of the world and comprises a bulk of global assets that are dollar-denominated.
Remember leverage? Well, let’s examine it’s relation to its big brother -- debt.
In general, the US economy, and the broader world, are overleveraged significantly. This means that there’s drastically more debt in the system than actual dollars supporting that debt. With various debt instruments maturing at different times, this is sustainable during non-volatile periods. But not currently.
Dollars are pledged many times over around the world, meaning that when everyone is looking for dollars (like now) there’s going to be a supply shortage.
To compensate, the Fed is expanding its balance sheet at an obscene pace, injecting cash into the global financial system, and will likely end up printing the difference on any fiscal stimulus pending spending cuts that are not popular with Congress and our oversized federal government. In addition, the Fed is reportedly considering swap lines with foreign banks, outside of solely the G7, which means more USD for foreign countries during the crisis. It may not be enough still.
So, to recap along with some takeaways:
Funds that replaced a key liquidity function of banks desperately need dollars but cannot access them.
Banks can access the Fed Bazooka but don’t want it.
Foreign institutions desperately want USD too.
Corporations are blowing through cash-flows, likely on the verge of collapse. They want USD too.
Small businesses are shuttered or have no business because of quarantine. Fiscal stimulus will not save all of them. They want USD too.
Overpledged dollars are in short supply, inducing growth of the Fed Bazooka and injection of more dollars into the global economy (e.g., swap lines).
The USD screeching higher as demand shoots up has negative effects on many aspects of the global economy.
The long-term effects of Fed Bazooka could be teetering on the edge of dangerous inflation levels.
Conclusion -- markets are seizing up, dollar demand is skyrocketing, the economy is virtually paralyzed, businesses are burning through small cash reserves, and the only solution is the Fed pumping in trillions paired with the planned multi-trillion government fiscal stimulus package.
Here’s the problem: due to the Fed’s incessant need to intervene in markets since the 1970s and artificially suppress interest rates, price discovery and critical risk pricing markers like Treasury Notes are totally out-of-whack. Similarly, stemming from overt risk in 2008 and the regulatory fallout, the entities that need cash cannot access that cash in a classic government-induced Catch 22.
In the human body analogy, the Fed’s perpetual abuse of the QE and low-interest rate drug has weakened the immune system of the financial system. The ongoing effects are now symptoms of a grave illness stemming from the drug abuse of the Fed that will cause long-term damage to the global economy, political landscape, and American society.
We’re in the midst of an unprecedented liquidity crunch that was induced by a viral pandemic that shocked global supply chains in a Black Swan event that coincided with nosediving oil prices, burst the corporate credit bubble, and sank the key players in the liquidity apparatus of the financial market infrastructure. Surging dollar demand and quarantined economies that destroy small businesses followed suit.
The scramble for USD will be unprecedented and scary. Markets are in complete turmoil and the basic levers needed to keep the system afloat are failing.
Now for some news that will rustle more than a few feathers.
It appears that the Fed, government, and banks will find a way to bail out the funds. And they will do it as subtly as possible. Yes, bailing out hedge funds is crazy. I know, I’m not arguing with you. At the same time, corporations like the airline industry, which eschewed normal-sized bathroom R&D for share buybacks that made their CEOs mega-wealthy will also be bailed out. Even the cruise industry, which I always assumed was just a social construct, will be bailed out.
Considering that small businesses have variable funding needs coming out of this crisis, it appears that a blanket approach fiscal policy response is all that’s available to the government. In another “stunning” myopic characteristic of central planning, the limits of knowledge prevent the government from crafting custom responses to small business needs independently, and only allows them to buttress specific, major sectors like airlines and hotels.
The federal government is too big.
Many small businesses in America, which account for 44 percent of American economic activity, will fail. It’s one of the more depressing outcomes of the entire charade.
All of it could’ve been avoidable without artificially low-interest rates for decades.
Corporations wouldn’t be enticed to take out massive loans and use them to inflate their asset prices (stocks) and would instead, do useful stuff. For example, maybe Boeing could’ve spent more R&D on their shitty new passenger plane that remains grounded and killed hundreds of people.
Passive funds would be much more risk savvy and not feel the need to play with the interminable fire of high leverage on passive financial instruments. Markets wouldn’t be pulling a Black Monday every other day, stunning even fractal Mandelbrot’s Brownian model enthusiasts. And news cycles would be way less annoying, reducing everyone’s daily exposure to useless commentary.
Society would be a generally happier place.
Instead, we’re stuck in a dystopian nightmare where the sagacious neighborhood dealers (of the illicit variety) have transitioned to toilet paper -- not gold, bitcoin, weed, cocaine, or the even the venerated USD in a liquidity crunch.
Again, we’re only in the early stages of this monster, and time will tell what happens. This is my brief synopsis of what has happened so far for curious mainstream readers wondering what the hell is going on behind the convoluted curtain of modern finance.
There will, of course, be both explicit and nuanced errors in this essay, and I admittedly had to gloss over many granular aspects, like the recently announced commercial paper facility, swap lines, money market mutual fund backstop, and temporary lift on all home foreclosures. The goal was to shed some light on the overarching interdependencies of a fragile financial system and how COVID-19 affected them in the tempestuous past few weeks.
Finance is not an easy topic to grasp at the macro scale, but hopefully, this helped some people understand what’s happening beyond what talking heads on CNN are blabbering about.
Hell, the NYT editorial board can’t even do basic math anymore.
Stay safe out there.
P.S. I tried to write this in my spare time in like 2 days because at the rate everything is moving I fully expect the Zombie Apocalypse or Aliens to pop up by April. This is one of those times when decades happen in weeks.
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